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CHAPTER 2: ACCOUNTING FOR TRANSACTIONS
I. FINANCIAL STATEMENTS
A. Income Statement
Describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.
Examples of accounts on form: Consulting revenue, rental revenue, advertising expense, rent expense, salaries expense
B. Statement of Retained Earnings
Explains changes in retained earnings from net income (or loss) and from any dividends over a period of time.
Examples of accounts on form: retained earnings for April 1, 2009, Net Income or (net loss), Dividends, retained earnings for April 30, 2009
C. Balance Sheet
Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.
Examples of accounts on form: assets like cash, accounts receivable, supplies, equipment; liabilities like accounts payable; equity like common stock and retained earnings
D. Statement of Cash Flows
Identifies cash inflows (receipts) and cash outflows (payments) over a period of time.
Has three sections: 1st^ section on cash flows from Operating Activities, 2nd^ section reports Investing Activities, and the 3 rd^ section shows cash flows from Financing Activities.
Examples of accounts on form: cash from operating activities, purchase of equipment, investments by stockholder, dividends to stockholder
Corporation’s equity is called stockholders’ equity or shareholders’ equity.
Revenues— increase in company resources from the sale of goods or services.
Examples: consulting services provided, sales of products, facilities rented to others, commissions from services
Expense— costs encountered in the normal course of business.
Examples: costs of employee time, use of supplies, advertising from others, utilities from others
Net Income— an overall measure of performance for the period which equals revenues less expenses.
4. Equation
a. Basic Accounting Equation
Assets = Liabilities + Equity
Assets must be equal to the claims against those assets.
If you have an asset, we can have two broad categories of claims against that asset.
First, we may have claims by creditors, liabilities.
Secondly, after all creditor claims are satisfied, owners and stockholders have a claim on those assets.
b.
Assets = Liabilities + Equity
+ - - + - +
Expanded Accounting Equation
Common stock— when an owner invests in a company in exchange for common stock.
Dividends— a corporation’s distribution of assets to its owners; it reduces the equity account.
B. Transaction Analysis
Business activities can be described in terms of transactions and events.
Events— are happenings that affect an entity’s accounting equation AND can be reliably measured.
Examples: changes in the market value of certain assets and liabilities, natural events such as floods and fires that destroy assets and create losses
During the process of recording business transactions, it is IMPORTANT to always keep the accounting equation in balance. We can’t let our books get out of balance.
III. ANALYZING AND RECORDING PROCESS
The accounting process identifies business transactions and events, analyzes and records their effects, and summarizes and presents information in reports and financial statements.
External transactions— where external parties like creditors, customers, financial institutions and owners have exchanges of value between the two entities.
- Asset Accounts
Assets— are resources owned or controlled by a company and that have expected future benefits.
Examples: cash, accounts receivable, note receivable (or promissory note), prepaid accounts, supplies, equipment, buildings, land
a. Cash
Reflects a company’s cash balance.
All increases and decreases in cash are recorded in this account.
Examples: money and any medium of exchange that a bank accepts for deposit (coins, checks, money orders, and checking account balances)
b. Accounts Receivable
Also called credit sales or sales on account (or on credit ).
Are promises of payment from customers to sellers.
Customers charge the item with the seller, get to take the item home and pay for it later.
Account receivables are increased by credit sales.
Account receivables are decreased when customers make payments.
c. Note Receivable (or Promissory Note)
Is a written promise of another person to pay a definite sum of money on a specified future date to the holder of the note.
A company that is holding a promissory note signed by another person (entity) has an asset that is recorded in a Note (or Notes) Receivable account.
d. Prepaid Accounts (also called Prepaid Expenses)
Are assets that represent prepayments of FUTURE expenses (NOT current expenses).
When the expense finally happens through the passage of time or are used up, the amounts in prepaid accounts are transferred to expense accounts.
Examples: prepaid insurance, prepaid rent, prepaid services (such as club memberships)
Prepaid accounts are adjusted when the financial statements are prepared so that: (1) all expired and used prepaid accounts are recorded as regular expenses and (2) all unexpired and unused prepaid accounts are recorded as assets.
Example: a premium is an insurance fee that is paid in advance for a certain length of time (i.e. one year). It is listed as Prepaid Insurance and is an asset for the insurance coverage that we have paid for in advance but haven’t used yet. Once we use up a month’s worth of insurance, it is deducted from the worth of Prepaid Insurance (an asset) and is recorded as an expense.
e. Supplies
Are considered assets until they are used.
When used up, their costs are reported as expenses.
Are grouped by purpose—Office Supplies, Store Supplies
Office Supplies includes stationery, paper, toner, pens.
Store Supplies includes packaging materials, plastic and paper bags, gift boxes and cartons, cleaning materials.
f. Equipment
Is an asset.
Are grouped by purpose—Office Equipment, Store Equipment
Office Equipment includes computers, printers, desks, chairs, and shelves.
It can also happen from purchases of supplies, equipment, and services.
b. Notes Payable
A formal promise, usually indicated by the signing of a promissory note, to pay a future amount.
Depending on when it is to be paid, it can be recorded either to a short-term Note Payable account or a long-term Note Payable account.
c. Unearned Revenue
Revenue— also called sales
Is when the cash has been received but the product or service has not been delivered.
Example: you subscribe to a magazine, you pay a one -year subscription in advance. The publishing company has received cash but nothing has been done to earn that revenue. As the magazine is delivered to you, the publishing company recognizes a portion of the money received as revenue. At the end of the year, all the revenue will be earned and the liability no longer exists.
d. Accrued Liabilities
Amounts owed that are not yet paid.
Examples: Wages Payable, Taxes Payable, Interest Payable
- Equity Accounts
Also called stockholders’ equity, or shareholders’ equity
Is the owner’s claim on a corporation’s assets.
Equity is the owners’ remaining interest in the assets of a business after deducting liabilities.
Equity is affected by four accounts: common stock, dividends, re venues, and expenses.
a. Common Stock
When an owner invest in a company in exchange for a share/stock in the company.
Increases equity.
b. Dividends
Opposite of owner investment and decreases equity.
It’s the distribution of assets to the stockholders.
Is an account used in recording asset distribution to stockholders/owners.
c. Revenues
When products and services are sold or provided to customers.
Increases equity.
Examples: Sales, Commissions Earned, Professional Fees Earned, Rent Earned, Interest Revenue
d. Expenses
Result from assets and services used in a company’s operation.
Decreases equity.
Examples: Advertising Expense, Store Supplies Expense, Office Salaries Expense, Office Supplies Expense, Rent Expense, Utilities Expense, Insurance Expense
Debit balance— when the sum of the debits exceeds the sum of the credits.
Credit balance— when the sum of the credits exceeds the sum of the debits.
Zero balance— when the sum of debits equals the sum of credits.
C. Double-Entry Accounting
Double-entry accounting— requires that each transaction affects at least two accounts and is recorded in two accounts.
it also means that the total debits of a transaction must equal the total credits.
With transactions, if you increase one side of the accounting equation, you must increase the other side.
If you decrease one side of the accounting equation, you must decrease the other side.
If the transaction affects only one side of the accounting equation, then one account is increased and one account is decreased.
Dividends, Expenses, Assets (DEA) have Normal Balances on the Debit side OR on the side that you increase.
Liabilities, Equity, Common Stock, Revenues (LECR) have Normal Balances on the Credit side OR on the side that you increase.
Equity has 4 sub-categories: Common Stock, Dividends, Revenue, Expenses.
Common Stock and Revenues INCREASE Equity on the Credit side.
Dividends and Expenses DECREASE Equity on the Debit side.
D. Journalizing and Posting Transactions
Journal— gives a complete record of each transaction in one place.
Journalizing— is the process of recording transactions in a journal.
Posting— the process of transferring journal entry information to the ledger.
Steps in Processing Transactions:
Analyze transactions and source documents.
Apply double-entry accounting by putting it into T-accounts.
Record each transaction in a journal as a journal entry.
Post journal entry to the ledger.
- Journalizing Transactions
General Journal— an all-purpose journal for recording the debits and credits of transactions and events.
Posting Reference (PR) column— is left blank in a manual system when entering a transaction in the General Journal. Later this column will be filled in with a number when you post to the Ledgers.
The General Journal can be used to record any transaction and includes the following information:
date of transaction
titles of affected accounts
dollar amount of each debit and credit
explanation of the transaction
Posting creates a link and a cross-reference between the ledger and the General Journal entry.
All entries must be posted to the ledgers before financial statements can be prepared.
If it is a debit in the General Journal, then it is a debit in the Ledger.
Steps to post a journal entry:
Identify the ledger account that is debited in the entry; then, in the ledger, enter the entry date, the journal and page in its PR column, the debit amount, and the new balance of the ledger.
Enter the ledger account number in the PR column of the General Journal.
and 4) Repeat the first two steps for credit entries and amounts.
E. Analyzing Transactions—An Illustration
ANALYSIS Identify 1. Determine what accounts are affected.
Classify 2. Determine what kind of account it is (i.e. asset, liability, etc.)
+/- 3. Determine if each account increases or decreases
Balance 4. Determine if the accounting equation is in balance.
Debit/Credit Rule _Which account is debited?__________________________________
_Which account is credited? __________________________________
T-Accounts
- Investment by Owner
Assets = Liab + Equity
Double Entry: (1) Cash
Common Stock
Cash +
Accts Recv
Supp
Prepd
Insur
Equip-
ment
Accts
Pay +
Commo n
Stock
Divi- dends
+ Reven
ue
- (^) Exp
Bal. 0 0 0 0 0 = 0 0 0 0 0
1 +30,000^ +30,
Bal. 30,000 + 0 + 0 + 0 + 0 = 0 + 30,000 - 0 + 0 - 0
TRANSACTION #1: Shareholders invested $30,000 in FastForward on Dec. 1.
ANALYSIS Identify 1. Cash; Common Stock
Classify 2. CashAsset; Common StockEquity
+/- 3. Cash + ; Common Stock +
Balance 4. The equation is balanced
Debit/Credit Rule Which account is debited? Cash
Which account is credited? Common Stock
T-Accounts
Cash Common Stock
30,
- Purchase Equipment for Cash
Assets = Liab + Equity
Double Entry: (3) Equipment
Cash
Cash +
Accts Recv
Supp
Prepd
Insur
Equip-
ment
Accts
Pay +
Commo n
Stock
Divi- dends
+ Reven
ue
- Exp
Bal. 27,500 0 2,500 0 0 = 0 30,000 0 0 0
Bal. 1,500 + 0 + 2,500 + 0 + 26,000 = 0 + 30,000 - 0 + 0 - 0
TRANSACTION #3: FastForward purchases equipment by paying $26,000 cash.
ANALYSIS Identify 1. Equipment; Cash
Classify 2. EquipmentAsset; CashAsset
+/- 3. Equipment + ; Cash -
Balance 4. The equation is balanced
Debit/Credit Rule Which account is debited? Equipment
Which account is credited? Cash
T-Accounts
Equipment Cash
26,
- Purchase Supplies on Credit
Assets = Liab + Equity
Double Entry: (4) Supplies
Accounts Payable
Cash +
Accts Recv
Supp
Prepd
Insur
Equip-
ment
= Accts
Pay +
Commo n
Stock
Divi- dends
+ Reven
ue
- (^) Exp
Bal. 1,500 0 2,500 0 26,000 = 0 30,000 0 0 0
Bal. 1,500 + 0 + 9,600 + 0 + 26,000 = 7,100 + 30,000 - 0 + 0 - 0
TRANSACTION #4: FastForward purchases $7,100 of supplies on credit.
ANALYSIS Identify 1. Supplies; Accounts Payable
Classify 2. SuppliesAsset; Accounts PayableLiability
+/- 3. Supplies + ; Accounts Payable +
Balance 4. The equation is balanced
Debit/Credit Rule Which account is debited? Supplies
Which account is credited? Accounts Payable
T-Accounts
Supplies Accounts Payable
7,
