Financial & Managerial Accounting: Chapter 2 - Analyzing Transactions

Chapter Objectives

• By the end of this chapter, you should be able to:

  • Obj. 1: Describe the characteristics of an account and a chart of accounts.

  • Obj. 2: Describe and illustrate journalizing transactions using the double-entry accounting system.

  • Obj. 3: Describe and illustrate the journalizing and posting of transactions to accounts.

  • Obj. 4: Prepare an unadjusted trial balance and explain how it can be used to discover errors.

  • Obj. 5: Describe and illustrate the use of horizontal analysis in evaluating a company's performance and financial condition.

Using Accounts to Record Transactions (1 of 4) (Learning Objective 1)

• Accounting systems are designed to show the increases and decreases in each accounting equation element as a separate record.

• This record is called an account.

• An account, in its simplest form, has three parts:

  • A title: This is the name of the accounting equation element recorded in the account.

  • A space for recording increases: This section records increases in the amount of the element.

  • A space for recording decreases: This section records decreases in the amount of the element.

Using Accounts to Record Transactions (2 of 4)

• The account form that follows is called a T account because it resembles the letter T.

• The left side of the account is called the debit side, and the right side is called the credit side.

Using Accounts to Record Transactions (3 of 4)

• The amounts shown in the Cash column of Exhibit 1 would be recorded in a cash account as follows:

Using Accounts to Record Transactions (4 of 4)

• Recording transactions in accounts must follow certain rules:

  • Increases in assets are recorded on the debit (left side) of an account.

  • Decreases in assets are recorded on the credit (right side) of an account.

  • The excess of the debits of an asset account over its credits is the balance of the account.

  • Example of cash account balance computation:

  • Debits:

    • Cash received: $25,000

    • Cash from customers: $7,500

    • Total Debits: 25,000 + 7,500 = 32,500

  • Credits:

    • Cash paid (total to creditors): $20,000 + $3,650 + $950 + $2,000 = $26,600

  • Balance of Cash as of November 30, 20Y3: 5,900 = 32,500 - 26,600

Chart of Accounts (1 of 2)

• A group of accounts for a business entity is called a ledger.

• A list of the accounts in the ledger is called a chart of accounts.

• The accounts are normally listed in the order in which they appear in the financial statements:

  • Balance sheet accounts are listed first in the order of:

  • Assets

  • Liabilities

  • Stockholders’ equity

  • Income statement accounts are then listed in the order of:

  • Revenues

  • Expenses

Chart of Accounts (2 of 2)

• Assets are the rights of a business entity to economic benefits.

• Liabilities are obligations by a business entity to transfer assets to third parties.

• Stockholders’ equity is the stockholders’ right to the assets of the business, represented by the balance of:

  • Common stock

  • Retained earnings accounts.

• A dividends account represents distributions of earnings to stockholders.

• Revenues are increases in assets and stockholders’ equity due to selling services or products to customers.

• Expenses are costs incurred from using up assets or consuming services in the process of generating revenues.

Exhibit 2 – Chart of Accounts for NetSolutions

• Balance Sheet Accounts:

  1. Assets:

  • 11 Cash

  • 12 Accounts Receivable

  • 14 Supplies

  • 15 Prepaid Insurance

  • 17 Land

  • 18 Office Equipment

  1. Liabilities:

  • 21 Accounts Payable

  • 23 Unearned Rent

  1. Stockholders’ Equity:

  • 31 Common Stock

  • 32 Retained Earnings

  • 33 Dividends

• Income Statement Accounts:

  4. Revenue:

  • 41 Fees Earned

  4. Expenses:

  • 51 Wages Expense

  • 52 Supplies Expense

  • 53 Rent Expense

  • 54 Utilities Expense

  • 59 Miscellaneous Expense

Knowledge Check Activity 1

• Which of the following would be considered an asset in a company’s chart of accounts?

  • Accounts Payable

  • Factory Equipment

  • Travel Expense

  • Revenue

• Answer: Factory Equipment is a resource owned by a business entity.

Double-Entry Accounting System (Learning Objective 2)

• All businesses use what is called the double-entry accounting system, which is based on the accounting equation and requires:

  • Every business transaction to be recorded in at least two accounts.

  • The total debits recorded for each transaction to be equal to the total credits recorded.

• The double-entry accounting system has specific rules of debit and credit for recording transactions in the accounts.

Balance Sheet Accounts

• The debit and credit rules for balance sheet accounts are:

  • … [Further details needed]

Income Statement Accounts

• The debit and credit rules for income statement accounts are based on their relationship with stockholders’ equity:

  • … [Further details needed]

Statement of Stockholders’ Equity Accounts (Dividends)

• The debit and credit rules for recording dividends are based on the effect of dividends on stockholders’ equity (retained earnings).

• … [Further details needed]

Exhibit 3 – Rules of Debit and Credit, Normal Balances of Accounts

• The details of the rules related to debit/credit balances can be linked here; more detailed descriptions are needed.

Journalizing (1 of 2)

• Using the rules of debit and credit, transactions are initially entered in a record called a journal.

• The journal serves as a record of when transactions occurred and were recorded.

Journalizing (2 of 2)

• The transaction is recorded in the journal using the following steps:

  • Step 1: The date of the transaction is entered in the Date column.

  • Step 2: The title of the account to be debited is recorded in the left-hand margin under the Description column, and the amount to be debited is entered in the Debit column.

  • Step 3: The title of the account to be credited is listed below and to the right of the debited account title, and the amount to be credited is entered in the Credit column.

  • Step 4: A brief description may be entered below the credited account.

  • Step 5: The Post. Ref. (Posting Reference) column is left blank when the journal entry is initially recorded; this column is used later in this chapter when the journal entry amounts are transferred to the accounts in the ledger.

Exhibit 4 – Transaction Terminology and Related Journal Entry Accounts

• Common Transaction Terminology:

  • Debit: Received cash for services provided

  • Accounts affected: Cash - Fees Earned

  • Provided services on account

  • Accounts affected: Accounts Receivable - Fees Earned

  • Received cash on account

  • Accounts affected: Cash - Accounts Receivable

  • Purchased on account

  • Accounts affected: Asset account - Accounts Payable

  • Paid on account

  • Accounts affected: Accounts Payable - Cash

  • Paid cash

  • Accounts affected: Cash - Asset or expense account

  • Issued common stock

  • Accounts affected: Cash and/or other assets - Common Stock

  • Paid dividends

  • Accounts affected: Dividends - Cash

Transactions (a-h)

• Transaction a (Nov. 1): Chris Clark deposited $25,000 in a bank account in the name of NetSolutions in exchange for common stock.

• Transaction b (Nov. 5): NetSolutions paid $20,000 for the purchase of land as a future building site.

• Transaction c (Nov. 10): NetSolutions purchased supplies on account for $1,350.

• Transaction d (Nov. 18): NetSolutions received cash of $7,500 from customers for services provided.

• Transaction e (Nov. 30): NetSolutions incurred the following expenses: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275.

• Transaction f (Nov. 30): NetSolutions paid creditors on account, $950.

• Transaction g (Nov. 30): NetSolutions determined that the cost of supplies on hand at November 30 was $550.

• Transaction h (Nov. 30): Paid dividends, $2,000.

Posting Journal Entries to Accounts (Learning Objective 3)

• A transaction is first recorded in a journal.

• Periodically, the journal entries are transferred to the accounts in the ledger, a process known as posting.

• Although T accounts are useful for illustrating the recording and posting of transactions, more formal, multi-column accounts are used in practice:

  • A four-column account has Date, Item, and Posting Reference (Post. Ref.) columns as well as Debit and Credit columns for posting transactions.

Further Transactions (1-6)

• Transaction 1 (Dec. 1): NetSolutions paid a premium of $2,400 for an insurance policy for liability, theft, and fire, covering a one-year period.

• Transaction 2 (Dec. 1): NetSolutions paid rent for December, $800.

• Transaction 3 (Dec. 1): NetSolutions received an offer from a local retailer to rent the land purchased on November 5; they received $360 for rent for three months.

• Transaction 4 (Dec. 4): NetSolutions purchased office equipment on account from Executive Supply Co. for $1,800.

• Transaction 5 (Dec. 6): NetSolutions paid $180 for a newspaper advertisement.

• Transaction 6 (Dec. 11): NetSolutions paid creditors $400.

Remaining Transactions (7-18)

• Transaction 7 (Dec. 13): NetSolutions paid a receptionist and a part-time assistant $950 for two weeks’ wages.

• Transaction 8 (Dec. 16): NetSolutions received $3,100 from fees earned for the first half of December.

• Transaction 9 (Dec. 16): Fees earned on account for the first half of December totaled $1,750.

• Transaction 10 (Dec. 20): NetSolutions paid $900 to Executive Supply Co. on the $1,800 debt.

• Transaction 11 (Dec. 21): NetSolutions received $650 from customers in payment of their accounts.

• Transaction 12 (Dec. 23): NetSolutions paid $1,450 for supplies.

• Transaction 13 (Dec. 27): NetSolutions paid $1,200 for wages.

• Transaction 14 (Dec. 31): NetSolutions paid its $310 telephone bill.

• Transaction 15 (Dec. 31): NetSolutions paid its $225 electric bill.

• Transaction 16 (Dec. 31): NetSolutions received $2,870 from fees earned for the second half of December.

• Transaction 17 (Dec. 31): Fees earned on account for the second half of December totaled $1,120.

• Transaction 18 (Dec. 31): Paid dividends, $2,000.

Exhibit 6 – General Ledger for NetSolutions

• Details of the general ledger reflecting account balances are included here; however, specifics are not provided in the transcript.

Using Data Analytics

• When a company uses data analytics to solve a problem, it must first extract relevant data.

• The nature of the problem dictates the type of data extracted, which may be:

  • Quantitative data: Numeric data used for mathematical operations, e.g., average revenue per customer.

  • Categorical data: Observations often summarized as proportions or percentages.

Knowledge Check Activity 2

• Question: Which of the following is the process of transferring debits and credits from journal entries into accounts in a ledger?

• Options:

  • Bookkeeping

  • Ledgering

  • Journalizing

  • Posting

• Answer: Posting

Trial Balance (Learning Objective 4)

• Errors may occur in posting debits and credits from the journal to the ledger. One way to detect such errors is by preparing a trial balance.

• Double-entry accounting requires that debits must always equal credits; the trial balance verifies this equality.

• The steps in preparing a trial balance are:

  • Step 1: Name the company, title of the trial balance, and preparation date.

  • Step 2: List accounts from the ledger with respective debit or credit balances in the Debit or Credit column.

  • Step 3: Total the Debit and Credit columns.

  • Step 4: Verify that the total of the Debit column equals the Credit column.

Exhibit 7 – Trial Balance

• Details of the prepared trial balance are exhibited here; no specifics are given in the transcript.

Errors Affecting the Trial Balance

• If the trial balance totals are not equal, an error has occurred and must be found and corrected.

• Transposition error: Occurs when digits are copied incorrectly.

• Slide error: Occurs when an entire number is copied incorrectly one or more spaces to the right or left.

Errors Not Affecting the Trial Balance

• An error may occur that does not cause the trial balance totals to be unequal; a correcting journal entry is prepared if the error was already journalized and posted to the ledger.

• Example of a journalized error compared to the correct entry demonstrates how to identify correcting entries.

Discussion Activity 2

• Break into groups to discuss what steps to take when an unadjusted trial balance does not balance, exploring techniques for identifying errors in recording and posting.

Analysis for Decision Making: Horizontal Analysis (Learning Objective 5)

• Horizontal analysis compares each item on a current financial statement with the same item on an earlier statement, computing percentage increases or decreases against a base item.

• Comparing net income across periods shows improvement in operating performance.

Conclusion Summary

• You have learned to:

  • Describe characteristics of accounts and a chart of accounts.

  • Illustrate journalizing transactions with double-entry accounting systems.

  • Prepare unadjusted trial balances and discover errors in the process.

  • Use horizontal analysis for evaluating financial performance.