Chapter 3 Part 2: Material in Exam 2 - Accounting Principles

Chapter 3 Part 2: Material in Exam 2 - Accounting Principles

Recording Transactions Using Journal Entries (JEs)

• Introduction: Presentation of transactions/events using the Horizontal Financial Statements Model (HFSM) alongside recording these in T Accounts using debits and credits.

Rules of Journal Entries:

1. Essential Components:

   • Each Journal Entry requires:

     • A Debit and A Credit.

   • HFSM Equivalent: Every transaction recorded in 2 places.

   • T Account Equivalent: Every transaction affects 2 T accounts.

2. Balance Requirement:

   • Your DEBITS and CREDITS must equal.

   • HFSM Equivalent: Balance After Each Transaction (BAE) is required.

   • Conclusion: Total debits must equal total credits, proportionally verified with the Account Equation.

3. Formatting Journal Entries:

   • Journal entries are always written on 2 lines.

   • Format: Always list the Debit first, then the Credit on the next line, followed by a description (if any).

   • All Journal Entries are recorded in the General Journal.

Understanding Debits and Credits: Properties of Accounts

• To determine what accounts will be debited or credited in a transaction, utilize either T accounts or the acronym DEAD CLOR:

  • Debit: Increases in Assets and Expenses

  • Credit: Increases in Liabilities, Equity, and Revenue

Example Transaction: Recording in HFSM and T Accounts

• Example Event 1: Received $20,000 cash for the issue of common stock.

  • Accounts involved:

    • Assets: Cash

    • Stockholders’ Equity: Common Stock

  • Representation:

    • Assets = Liabilities + Stockholders’ Equity

    • Cash = Note Payable + Common Stock + Retained Earnings

Exercise 3-17A - Recording in Journal and T-Accounts

• Transactions for Montgomery Co. (Year 1):

  1. Cash: Received $36,000 from issuing common stock.

  2. Services on Account: Performed $48,000.

  3. Operating Expenses: Incurred $6,500 on account.

  4. Salaries Expense: Paid $21,000 in cash.

  5. Accounts Receivable: Collected $34,500.

  6. Dividends: Paid $3,000 to stockholders.

  7. Services for Cash: Performed $9,500.

  8. Accounts Payable: Paid $5,500.

T Account Effects:

• Assets:

  • Cash:

  • Increases by 36,000

  • Decreases by 21,000 (salaries)

  • Decreases by 5,500 (accounts payable)

  • Increases by 34,500 (accounts receivable collection)

  • Increases by 9,500 (services for cash)

• Liabilities: Accounts Payable

• Stockholders’ Equity:

  • Common Stock: Increase by 36,000

  • Service Revenue: Increase by 48,000 from services performed, with a final balance of 57,500

  • Retained Earnings decreased due to dividends paid.

Recording Journal Entries for Transactions

• Journal Entries for Montgomery Co.:

  1. Cash — Debit: 36,000; Credit:
     Common Stock — Credit: 36,000

  2. Accounts Receivable — Debit: 48,000; Credit:
     Service Revenue — Credit: 48,000

  3. Other Operating Expenses — Debit: 6,500; Credit: Accounts Payable – Credit: 6,500

  4. Salaries Expense — Debit: 21,000; Credit: Cash – Credit: 21,000

  5. Accounts Receivable — Debit: 34,500; Credit:
     Cash – Credit: 34,500

  6. Dividends — Debit: 3,000; Credit: Cash – Credit: 3,000

Journal Entry Rules

• First Principle: List debits first always, credits last.

• Formatting Requirement: No parentheses or minus signs.

• Defining Credit/Debit: Amount determined by the change in the account, not the balance.

• Numerical Computing: Avoid commas or dollar signs during input to avoid reading errors in software.

Transactions to Record in General Journal

• Example entries for various transactions:

  1. Performed services on account for $8,200.

  • Debit: Accounts Receivable — $8,200

  • Credit: Service Revenue — $8,200

  1. Collected cash on accounts receivable for $5,600.

  • Debit: Cash — $5,600

  • Credit: Accounts Receivable — $5,600

Closing Entries

• Purpose of Closing Entries: Closing temporary revenue, expense, and dividend accounts into ones that impact Retained Earnings (RE).

1. Required Closure: These accounts are recorded separately then closed into Retained Earnings, leading to a zero balance.

2. Methods of Closing:

   • Each account may have a separate entry:

     • Revenue: Record revenue amounts;

     • Expense: Expense amounts;

     • Dividends: Close dividends set.

   • Alternatively, combine them into one entry.

Closing Entries Exercise (3-21A)

• Preparation of entries to close temporary accounts (Service Revenue, Expenses, Dividends).

Financial Statement Analysis - Ratios

1. Return on Assets Ratio (ROA): Measures profitability in relation to assets.

   • Calculation: ROA = rac{Net Income}{Total Assets}

2. Return on Equity Ratio (ROE): Measures profitability relative to shareholders' equity.

   • Calculation: ROE = rac{Net Income}{Total Equity}

3. Debt to Assets Ratio: Measures level of financial risk within a company.

   • Calculation: Debt ext{-}to ext{-}Assets = rac{Total Debt}{Total Assets}

Comparison of Financial Risk Between Companies

• Evaluation of two companies through their respective debt-to-assets ratios to determine which company carries greater financial risk, concluding which has a higher debt leverage.

  • For example: Company East vs. Company West may reveal one company has more assets funded through debt than another based on comparative ratios.