copyright © cengage learning. all rights reserved. chapter 2 analyzing business transactions

Copyright © Cengage Learning. All rights reserved.

Chapter 2

Analyzing Business Transactions

Copyright © Cengage Learning. 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.


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 Recognition for 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


Valuation

• Focuses on assigning a monetary value to a transaction.

• 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 transaction at 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.


Classification

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


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 DualityEach transaction recorded with at least one debit

and one credit. Total amount of debits = total amount of creditsWhole 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 Accounting– 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)


Accounts and the Accounting Equation

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(–)


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


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’ equityTransactions that increase revenues increase stockholders’ equity


Business Transaction Analysis

• Objective 3– Demonstrate how the double-entry system is applied to

common business transactions.


Investment in Company

Analyze

Apply rules

Record

July 1: Joan Miller invests $40,000 in Miller Design Studio, Inc. in exchange for 40,000 shares $1 par value 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


Purchase Assets

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 2 Prepaid Rent 3,200 Cash 3,200


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


Steps in Preparing a Trial Balance

1. List each T 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 ledger

2. Add each column

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


Trial BalanceMiller Design Studio, Inc.

Trial Balance July 31, 2010

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

Copyright © Cengage Learning. All rights reserved.

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.

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

2-27

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classification issue

cost principle

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