chapter 2 analyzing business transactions. copyright © houghton mifflin company. all rights...

Chapter 2

AnalyzingBusiness Transactions

Copyright © Houghton Mifflin Company. All rights reserved. 2 | 2

Measurement Issues

• Objective 1– Explain how the concepts of recognition,

valuation, and classification apply to business transactions and why they are important factors in ethical financial reporting.


Measuring Business Transactions

• Once you have determined that a transaction has occurred, you must decide:– When the transaction occurred

• The recognition issue

– What value to place on the transaction• The valuation issue

– How to categorize the components of the transaction

• The classification issue


Measurement Issues

Recognition issue

Valuation issue

Classification issue

• These issues underlie almost every major decision in financial accounting

• Measurement issues are controversial


Recognition

• Recognition means the recording of a transaction

• Refers to the difficulty of deciding when a business transaction occurred

• Point of recognition is important because it affects the financial statements


Point of Recognitionfor Sales and Purchases

• Sales and purchases of products– Usually recognized when title to merchandise

passes from the supplier to the purchaser and creates an obligation to pay

– Or, may set up a recognition point• Predetermined time at which a transaction should

be recorded


Economic Events

Receiving products previously ordered

Ordering products from suppliers

Paying employees for work performed

Hiring new employees

Customer buys a serviceCustomer inquires about a service

Events that are not recorded as transactions

Events that are recorded as transactions


Valuation

• Focuses on assigning a monetary value to a transaction

• Most controversial issue in accounting

• According to GAAP, use original cost– Also called historical cost

• Practice of recording transactions at cost follows the cost principle


Cost Principle

• The principle that a purchased asset should be recorded at its actual cost– Cost

• Exchange price associated with a business transactionat the point of recognition

– Exchange price• Amount a buyer is willing to pay and a seller is willing to

receive• Is objective

• Cost principle is used because cost is verifiable


Applying the Cost Principle

Company BCompany A

1. Company A purchases building for $80,000

2. Company A offers same building for sale for $120,000

Company A• Records sale of building at sales price

(exchange price) of $110,000 and profit or loss is recognized

Company B• Records purchase of building at cost

(exchange price) of $110,000

Company A• Records purchase of building at original cost (exchange price) of $80,000

3. Company A sells building to Company B for $110,000

Only amounts involved in business transactions (exchanges of value) are recorded in the company books


Classification

• Classification is the process of assigning transactions to the appropriate accounts

• Proper classification depends on– Correctly analyzing the effect of each transaction

on the business– Maintaining a system of accounts that reflects

that effect


Ethics and Measurement Issues

• Ethical reporting requires that recognition, valuation, and classification are treated properly.

• Recording a lease agreement at the time leases are signed rather than over the lease term violates guidelines of recognition.

• Classifying an expenditure as an asset instead of an expense can be a classification violation.


Stop & Apply

Q. What three issues underlie most accounting decisions?

A. 1. The recognition issue– When a transaction should be recorded

2. The valuation issue– What value should be placed on the transaction

3. The classification issue– How the components should be categorized


Double-Entry System

• Objective 2

– Explain the double-entry system and the usefulness of T accounts in analyzing business transactions.


Example:Pay cash to purchase suppliesCash paid = effort, sacrifice, sourceSupplies received = reward, benefit, use

What Is the Double-Entry System?

• Based on principle of duality– Every economic event has two aspects that

balance, or offset, each other

– The two aspects represent

• Effort and reward

• Sacrifice and benefit

• Source and use


Principle of Duality

• Each transaction recorded with at least one debit and one credit

• Total amount of debits = total amount of credits

• Whole system always in balance

• All accounting systems based on principle of duality


Accounts

• Basic storage units for accounting data

• Used to accumulate amounts from similar transactions

• Separate accounts used for:– Assets– Liabilities– Components of stockholders’ equity (includes

revenues and expenses)


Three parts:

Title of Account

2. A left side, called the debit side

Debit(left) side

3. A right side, called the credit side

Credit(right) side

1. A title that describes the account

The T Account


Analyzing Business Transactions

• Rules of Double-Entry Bookkeeping – Every transaction affects at least two accounts

• One or more accounts must be debited and one or more accounts must be credited

– Total debits must equal total credits • For each transaction

• For whole system (all accounts as a group)


Rules of Double-Entry Accounting Stockholders’Assets = Liabilities + Equity

Debitfor

Increases(+)

Creditfor

Increases(+)

Creditfor

Increases(+)

Assets increase with debits

Liabilities and Stockholders’ Equity increase with credits

Assets decrease with credits

Creditfor

Decreases(–)

Liabilities and Stockholders’ Equity decrease with debits

Debitfor

Decreases(–)

Debitfor

Decreases(–)


Components of Stockholders’ Equity

• Common stock

• Retained earnings

• Dividends

• Revenues

• Expenses


Effects of Dividends, Revenues,and Expenses on Stockholders’ Equity

Stockholders’ Equity

Common + Retained – Dividends + Revenues – Expenses Stock Earnings

• Dividends and expenses decrease stockholders’ equity– Transactions that increase dividends or expenses

decrease stockholders’ equity

• Revenues increase stockholders’ equity– Transactions that increase revenues increase

stockholders’ equity


Normal Balance for Asset, Dividend, and Expense accounts:

Debit side

Normal Balance for Liability, Common

Stock, Revenue, and Retained Earnings

accounts: Credit side

Normal Balance

• The usual balance of an account

• The side (debit or credit) that increases the account


Stockholders’ Equity Accounts

• Revenue and expense accounts separated from other stockholders’ equity accounts

• Important for legal and financial reporting purposes– Stockholders’ equity accounts represent legal claims by

stockholders against assets of company

– Law requires that capital investments and dividends be separate from revenues and expenses for tax and financial reporting

– Management needs a detailed breakdown of revenues and expenses for budgeting and operating purposes


Stop & Apply

Q. What is an account?

A. Basic storage unit for accounting data. Means by which similar transactions are accumulated.


Business Transaction Analysis

• Objective 3– Demonstrate how the double-entry system

is applied to common business transactions.


Analyzing Business Transactions

1. State the transaction.

2. Analyze the transaction to determine which accounts are affected.

3. Apply the rules of double-entry accounting using T accounts.

4. Show the transaction in journal form.

5. Provide a comment that will help apply the rules of debit and credit.


Investment in the Business

Analyze

Apply rules

Record

July 1: Priscilla Treadle invests $40,000 in Treadle Website Design, Inc. in exchange for 40,000 shares $1 par value common stock.

Increase in assetsIncrease in stockholders’ equity

Debits increase assets (Cash)Credits increase stockholders’ equity (Common Stock)

Dr. Cr.

July 1 Cash 40,000 Common Stock 40,000


Prepayment of Expenses in Cash

Analyze

Applyrules

Record

July 3: Rents office and pays two months’ rent in advance, $3,200

Increase in assetsDecrease in assets

Debits increase assets (Prepaid Rent)Credits decrease assets (Cash)

Dr. Cr.

July 3 Prepaid Rent 3,200 Cash 3,200


Stop & Review

Q. Why does a business record an expense for the telephone bill even though it hasn’t been paid?

A. An expense has been incurred for telephone services used.An obligation to pay existsThe expense and the liability for telephone service

is recorded.


The Trial Balance

• Objective 4– Prepare a trial balance, and describe its

value and limitations.


The Trial Balance

• For every amount debited, an equal amount must be credited– Result: The total of debits and credits for all the

T accounts must be equal.

• Trial balance is prepared to test this– Usually prepared at the end of a month or

accounting period– Can be prepared anytime


Purpose of the Trial Balance

• The trial balance proves whether the ledger is in balance– Total of all debits recorded = Total of all credits recorded

• What it does not do– Prove that all transactions were analyzed correctly

– Prove that amounts were recorded in the proper accounts

– Detect whether transactions have been omitted

– Detect errors of the same amount made in both a debit and a credit


Steps inPreparing a Trial Balance

1. List each account that has a balance– Record debit balances in the left column– Record credit balances in the right column– List accounts in the order that they appear

in the financial statements

2. Add each column

3. Compare the column totals– Total debits should equal total credits


Trial BalanceTreadle Website Design, Inc.

Trial Balance July 31, 20xx

Cash $22,480

Accounts Receivable 4,600 Office Supplies 5,200 Prepaid Rent 3,200 Office Equipment 16,320 Accounts Payable $ 6,280 Unearned Design Revenue 1,400 Common Stock 40,000 Dividends 2,800 Design Revenue 12,400 Wages Expense 4,800 Utilities Expense 680 $60,080 $60,080

Record debit balances in left

column

Record credit balances in right

columnTotal each column


Finding Trial Balance Errors

• If the debit and credit columns are not equal, look for the following errors– A debit was entered in an account as a credit, or

visa versa– An incorrectly computed account balance– Error in carrying the account balance to the trial

balance– Trial balance summed incorrectly


Finding Trial Balance Errors (cont’d)

• If trial balance is out of balance by an amount divisible by 2– Caused by recording an account with a debit

balance as a credit, or visa versa

• If trial balance is out of balance by an amount divisible by 9– Caused by transposing two numbers when

transferring an amount to the trial balance


Stop & Review

Q.Why is the trial balance useful?

A.Proves that the debits and credits in the accounts are in balance after all transactions have been posted


Cash Flows and the Timing of Transactions

• Objective 5– Show how the timing of transactions affects

cash flows and liquidity.


• Some transactions generate immediate cash; others do not

A. A company bills a client for services rendered = cash receipt is delayed

B. A company performs services for cash = cash

receipt is immediate • Cash payments can be delayed by using credit terms offered by vendors

Cash Flows

• Companies must be able to pay bills on time


Cash

Inv. by owner 40,000 3,200 Prepay rent13,320 Purchase equipment

2,600 Payment on liabilityRevenue 2,800Advance revenue 1,400

Collection of A/R 5,000 4,800 Payment of wages2,800 Payment of dividends

Treadle must ensure that it has adequate cash on hand at all times to pay its debts and maintain

ongoing operations.

Bal. 22,480

Cash Flows:Treadle Website Design, Inc.


Stop & Review

Q.Why is the timing of cash receipts and payments important?

A.Companies must ensure that they have adequate funds on hand at all times to pay debts and continue operations.


Chapter Review

1. Explain how the concepts of recognition, valuation, and classification apply to business transactions and why they are important factors in ethical financial reporting.

2. Explain the double-entry system and the usefulness of T accounts in analyzing business transactions.

3. Demonstrate how the double-entry system is applied to common business transactions.


Chapter Review (cont’d)

4. Prepare a trial balance, and describe its value and limitations.

5. Show how the timing of transactions affects cash flows and liquidity.


Recording andPosting Transactions

• Supplemental Objective 6

– Define the chart of accounts, record transactions in the general journal, and post transactions to the ledger.


The General Journal

• Why aren’t transactions entered directly into the accounts?– Because the debit is recorded in one account and

the credit in another, it would be very difficult to• Identify individual transactions

• Find errors

• Solution– Record all transactions chronologically in a journal


Chart of Accounts

• A list of a firm’s account numbers and account titles

• The first digit in the account number identifies the major financial statement classification


General Journal

• General journal is the simplest and most flexible, also called book of original entry

• A separate journal entry records each transaction

• Journalizing is the process of recording transactions


Journalizing TransactionsRecord these items in a journal entry:

General Journal Page 1

Date

Description Post. Ref.

Debit

Credit

1. The date

1

4. Explanation of transaction

4

2. Names of accounts debited and dollar amounts on same line in debit column

2 2

3. Names of accounts credited (indented) and dollar amounts on same line in credit column

3 3

5. Account identification numbers, if appropriate

55


General Ledger

• Used to record the details of each transaction

• Used to update each account

• Ledger accounts are located in the general ledger

• Advantage of ledger account form over T account is that current balance of account is always available


Ledger Account Form

General Ledger

Accounts Payable Account No. 212

Balance Date

Item

Post. Ref.

Debit

Credit Debit Credit

• Account title and number appear at top of account form

• The date appears in the first two columns (as in the journal)

• Item column is rarely used because explanations already appear in the journal

• Post. Ref. column used to note journal page where the original entry for the transaction can be found

• Dollar amount of entry is entered in appropriate debit or credit column

• New account balance computed in final two columns after each entry


Posting

• Transferring journal entry information from the journal to the ledger

• Posting can be done daily, or less frequently depending on the number of transactions


Posting a Transaction General Journal Page 2

Date

Description

Post. Ref.

Debit

Credit

20xx July 30 Utilities Expense 680 Accounts Payable 680 Received bill from utility company

General Ledger Accounts Payable Account No. 212

Balance Date

Item

Post. Ref.

Debit

Credit Debit Credit

20xx July 5 J1 5,200 5,200

6 J1 3,000 8,200 9 J1 2,600 5,600

General Ledger Utilities Expense Account No. 512

Balance Date

Item

Post. Ref.

Debit

Credit Debit Credit

1. Locate debit account in the ledger

2. Enter date of transaction and journal page number in Post. Ref. column

3. Enter in Debit column amount of debit from journal

4. Calculate account balance and enter in appropriate Balance column

5. In journal Post. Ref. Column, enter account number to which amount was posted

6. Repeat for credit entry

512

212


Stop & Review

Q. In recording entries in a journal, which is written first, the debit or the credit? How is indentation used in the journal?

A. The debit entry is written first. The credit account title is indented once. The explanation is indented twice.

chapter 2 analyzing business transactions. copyright © houghton mifflin company. all rights...

Documents

cost principle slide

recognition recognition

business transactions

classification issue

objective cost principle

original cost exchange

controversial slide

verifiable slide