Basic Financial Accounting: Recording Business Transactions

Learning Objectives for Recording Business Transactions

Upon completion of this study material, the following objectives should be achieved:

• Listing and explaining in brief the sequential steps in the accounting cycle.
• Identifying the general journal as the book of original entry.
• Detailing the standard contents of the general journal.
• Outlining the steps in analyzing transactions and stating the role of source documents.
• Analyzing the impact of transactions on the elements and the specific accounts.
• Applying the rules of debits and credits in analyzing business transactions.
• Journalizing transactions in proper form.
• Describing a general ledger and understanding what purpose it serves.
• Posting entries from the general journal to the general ledger.
• Distinguishing between permanent and temporary accounts.
• Developing a chart of accounts.
• Preparing and explaining the use of a trial balance.
• Performing steps in locating and correcting errors.

The Analogy of Cycles: Weather vs. Accounting

• Frederic Fox ($34$ years old) illustrates the concept of identifying and exploiting technology. He acquired a business providing advisory services to large corporations and renamed it Strategic Weather Services ($SWS$) Inc.
• $SWS$ uses patented technology to forecast weather $12$ months in advance across North America and Europe, and analyzes business techniques to predict company success.
• By $1999$, the firm (with $90$ employees) projected sales of $US\$13.0$ million from three divisions:
  • A division for retailers and manufacturers based on long-range weather data.
  • A division for utility companies.
  • The WeatherPlanner website for consumers.
• Fox's interest began in $1993$ when he used $SWS$ meteorologists to ensure his wedding was rain-free. The WeatherPlanner concept officially hit the drawing board in $1994$.
• Just as Fox studies the weather cycle, entities study the accounting cycle to track their financial performance and position.

Transaction Analysis (Step $1$)

The process of analyzing transactions involves four fundamental steps:

1. Identify the transaction from source documents.
2. Indicate the accounts affected by the transaction, choosing from assets, liabilities, equity, income, or expenses.
3. Ascertain whether each account increased or decreased.
4. Apply rules of debit and credit to determine how to record the change.

Source Documents

• Source documents serve as the starting point of the accounting cycle.
• They provide original written evidence about the nature and amounts of transactions and events.
• They describe how transactions affect the financial position and performance of the entity.
• Common source documents include:
  • Sales invoices
  • Cash register tapes
  • Official receipts
  • Bank deposit slips
  • Bank statements
  • Checks
  • Purchase orders
  • Timecards
  • Statements of account

The Sequential Steps of the Accounting Cycle

The accounting cycle is a series of sequential procedures performed to accomplish the accounting process. It is repeated every accounting period.

• Step $1$: Identification of Events to be Recorded
  • Timing: During the accounting period.
  • Aim: Gather information about transactions or events via source documents.
• Step $2$: Transactions are Recorded in the Journal
  • Timing: During the accounting period.
  • Aim: Record the economic impact on the firm in a journal for easy transfer to accounts.
• Step $3$: Journal Entries are Posted to the Ledger
  • Timing: During the accounting period.
  • Aim: Transfer information from the journal to the ledger for classification.
• Step $4$: Preparation of a Trial Balance
  • Timing: End of the accounting period.
  • Aim: Provide a list to verify equality of debits and credits in the ledger.
• Step $5$: Preparation of the Worksheet including Adjusting Entries
  • Timing: End of the accounting period.
  • Aim: Assist in the preparation of financial statements.
• Step $6$: Preparation of the Financial Statements
  • Timing: End of the accounting period.
  • Aim: Provide useful information for decision-makers.
• Step $7$: Adjusting Journal Entries are Journalized and Posted
  • Timing: End of the accounting period.
  • Aim: Record accruals, expiration of deferrals, estimations, and other worksheet events.
• Step $8$: Closing Journal Entries are Journalized and Posted
  • Timing: End of the accounting period.
  • Aim: Close temporary accounts and transfer profit to owner's equity.
• Step $9$: Preparation of a Post-Closing Trial Balance
  • Timing: End of the accounting period.
  • Aim: Check equality of debits and credits after closing entries.
• Step $10$: Reversing Journal Entries are Journalized and Posted
  • Timing: Start of the next accounting period (optional).
  • Aim: Simplify the recording of regular transactions in the subsequent period.

The Journal: Book of Original Entry

• The journal is a chronological record of an entity's transactions.
• It shows the full effect of a transaction in terms of debits and credits before they reach the ledger.
• The General Journal is the simplest form. Its standard contents include:
  1. Date: Year and month are written once per page or when they change.
  2. Account Titles and Explanation: Debits are entered at the extreme left; credits are indented on the next line. A brief description follows below.
  3. P.R. (Posting Reference): Used later for cross-referencing ledger accounts.
  4. Debit: Column for debit amounts.
  5. Credit: Column for credit amounts.
• Simple Entry: Only two accounts are affected (one debit, one credit).
• Compound Entry: Three or more accounts are required.

Detailed Transaction Journalizing (Step $2$: Weddings "R" Us Case Study)

The following transactions occurred for Weddings "R" Us, founded by Dr. Rose Besario, during May $2021$.

May $1$: Initial Investment

• Transaction: Dr. Rose Besario invested $P250,000$ into the entity.
• Analysis: Assets ($A$) increase; Owner's Equity ($OE$) increases.
• Rules: Debit increases in Assets; Credit increases in Owner's Equity.
• Entry:
  • Debit: Cash ($A$) $P250,000$
  • Credit: Besario, Capital ($OE$) $P250,000$

May $1$: Rent Paid in Advance

• Transaction: Paid two months' rent in advance, $P8,000$.
• Analysis: Asset ($A$) increases (Prepaid Rent); Asset ($A$) decreases (Cash).
• Entry:
  • Debit: Prepaid Rent ($A$) $P8,000$
  • Credit: Cash ($A$) $P8,000$

May $2$: Note Issued for Cash loan

• Transaction: Borrowed $P210,000$ from Metrobank via a promissory note ($20\%$ annual interest), payable in one year.
• Analysis: Assets ($A$) increase; Liabilities ($L$) increase.
• Entry:
  • Debit: Cash ($A$) $P210,000$
  • Credit: Notes Payable ($L$) $P210,000$

May $3$: Hiring of Staff

• Staff: One office assistant and one account executive.
• Salary: $P7,800$ monthly each (or $P300$ per day for a $26$-day month).
• Note: No accounting entry is necessary at the point of hiring; work begins immediately.

May $4$: Service Vehicle Acquisition

• Transaction: Acquired service vehicle for $P420,000$ cash.
• Analysis: Asset ($A$) increases (Service Vehicle); Asset ($A$) decreases (Cash).
• Entry:
  • Debit: Service Vehicle ($A$) $P420,000$
  • Credit: Cash ($A$) $P420,000$

May $4$: Insurance Premiums

• Transaction: Paid Prudential Guarantee and Assurance, Inc. $P14,400$ for one-year coverage.
• Analysis: Asset ($A$) increases (Prepaid Insurance); Asset ($A$) decreases (Cash).
• Entry:
  • Debit: Prepaid Insurance ($A$) $P14,400$
  • Credit: Cash ($A$) $P14,400$

May $5$: Office Equipment on Account (Compound Entry)

• Transaction: Purchased equipment from Fair and Square Emporium for $P60,000$; paid $P15,000$ cash, balance due next month.
• Analysis: Asset ($A$) increases ($P60,000$); Asset ($A$) decreases ($P15,000$); Liability ($L$) increases ($P45,000$).
• Entry:
  • Debit: Office Equipment ($A$) $P60,000$
  • Credit: Cash ($A$) $P15,000$
  • Credit: Accounts Payable ($L$) $P45,000$

May $8$: Supplies on Credit

• Transaction: Purchased supplies from San Jose Merchandising for $P18,000$ on credit.
• Analysis: Assets ($A$) increase; Liabilities ($L$) increase.
• Entry:
  • Debit: Supplies ($A$) $P18,000$
  • Credit: Accounts Payable ($L$) $P18,000$

May $9$: Partial Settlement of Accounts

• Transaction: Paid San Jose Merchandising $P10,000$ for debt incurred May $8$.
• Analysis: Liabilities ($L$) decrease; Assets ($A$) decrease.
• Entry:
  • Debit: Accounts Payable ($L$) $P10,000$
  • Credit: Cash ($A$) $P10,000$

May $10$: Cash Revenue Collection

• Transaction: Collected bridal consulting fees for three couples at $P8,800$ each ($3 \times P8,800 = P26,400$).
• Analysis: Assets ($A$) increase; Owner's Equity ($OE:I$) increases.
• Entry:
  • Debit: Cash ($A$) $P26,400$
  • Credit: Consulting Revenues ($OE:I$) $P26,400$

May $13$: Salaries Payment

• Transaction: Paid salaries, $P6,600$.
• Analysis: Owner's Equity ($OE:E$) decreases; Assets ($A$) decrease.
• Entry:
  • Debit: Salaries Expense ($OE:E$) $P6,600$
  • Credit: Cash ($A$) $P6,600$

May $15$: Unearned Referral Revenues

• Transaction: Received $P10,000$ advanced referral fees for three clients.
• Analysis: Assets ($A$) increase; Liabilities ($L$) increase.
• Entry:
  • Debit: Cash ($A$) $P10,000$
  • Credit: Unearned Referral Revenues ($L$) $P10,000$

May $19$: Revenues on Account

• Transaction: Billed three couples $P12,000$ each for elaborate bridal arrangements ($3 \times P12,000 = P36,000$).
• Analysis: Assets ($A$) increase (Accounts Receivable); Owner's Equity ($OE:I$) increases.
• Entry:
  • Debit: Accounts Receivable ($A$) $P36,000$
  • Credit: Consulting Revenues ($OE:I$) $P36,000$

May $25$: Owner Withdrawal

• Transaction: Besario withdrew $P14,000$ for personal expenses.
• Analysis: Owner's Equity ($OE$) decreases; Assets ($A$) decrease.
• Entry:
  • Debit: Besario, Withdrawals ($OE$) $P14,000$
  • Credit: Cash ($A$) $P14,000$

May $27$: Salaries Payment

• Transaction: Paid salaries, $P7,200$.
• Entry:
  • Debit: Salaries Expense ($OE:E$) $P7,200$
  • Credit: Cash ($A$) $P7,200$

May $30$: Telephone Bill Incurred

• Transaction: Received utility bill of $P1,400$ from ICC-Bayan Tel.
• Analysis: Owner's Equity ($OE:E$) decreases; Liabilities ($L$) increase.
• Entry:
  • Debit: Utilities Expense ($OE:E$) $P1,400$
  • Credit: Utilities Payable ($L$) $P1,400$

May $30$: Collection of Accounts Receivable

• Transaction: Received $P24,000$ from two clients billed on May $19$.
• Analysis: Asset ($A$) increases (Cash); Asset ($A$) decreases (Accounts Receivable).
• Entry:
  • Debit: Cash ($A$) $P24,000$
  • Credit: Accounts Receivable ($A$) $P24,000$

May $31$: Electricity Bill Payment

• Transaction: Paid electricity bill of $P3,000$.
• Analysis: Owner's Equity ($OE:E$) decreases; Assets ($A$) decrease.
• Entry:
  • Debit: Utilities Expense ($OE:E$) $P3,000$
  • Credit: Cash ($A$) $P3,000$

The General Ledger

• The ledger is a grouping of an entity's accounts and is considered the "reference book" of the accounting system.
• It classifies and summarizes transactions to prepare data for financial statements.
• Accounts are divided into:
  1. Balance Sheet (Permanent) Accounts: Assets, liabilities, and owner's equity. Their balances carry over.
  2. Income Statement (Temporary) Accounts: Income and expenses (nominal accounts). These gather data for a specific period then transfer totals to owner's equity.
• Each ledger account maintains a format similar to a T-account but includes account numbers and journal references ($J.R.$).

Chart of Accounts: Weddings "R" Us

The chart of accounts lists all titles and their numbers, typically arranged by the order they appear in financial statements.

• Assets ($100s$):
  • $110$ Cash
  • $120$ Accounts Receivable
  • $130$ Supplies
  • $140$ Prepaid Rent
  • $150$ Prepaid Insurance
  • $160$ Service Vehicle
  • $165$ Accumulated Depreciation - Service Vehicle
  • $170$ Office Equipment
  • $175$ Accumulated Depreciation - Office Equipment
• Liabilities ($200s$):
  • $210$ Notes Payable
  • $220$ Accounts Payable
  • $230$ Salaries Payable
  • $240$ Utilities Payable
  • $250$ Interest Payable
  • $260$ Unearned Referral Revenues
• Owner's Equity ($300s$):
  • $310$ Besario, Capital
  • $320$ Besario, Withdrawals
  • $330$ Income Summary
• Income ($400s$):
  • $410$ Consulting Revenues
  • $420$ Referral Revenues
• Expenses ($500s$):
  • $510$ Salaries Expense
  • $520$ Supplies Expense
  • $530$ Rent Expense
  • $540$ Insurance Expense
  • $550$ Utilities Expense
  • $560$ Depreciation Expense - Service Vehicle
  • $570$ Depreciation Expense - Office Equipment
  • $580$ Miscellaneous Expense
  • $590$ Interest Expense

Posting Process (Step $3$)

Posting is the transfer of amounts from the journal to the ledger accounts.

1. Date: Transfer transaction date from journal to ledger.
2. Page Number: Transfer journal page number to the ledger's Journal Reference ($J.R.$) column.
3. Amounts: Post debits as debits and credits as credits.
4. Account Number: Enter the ledger account number in the journal's Posting Reference ($P.R.$) column once successfully transferred.

Account Balance Determination (Footing)

• At the end of a period, compute the balance by adding (footing) debits and credits.
• If Debits $>$ Credits, the account has a Debit Balance.
• If Credits $>$ Debits, the account has a Credit Balance.

Trial Balance (Step $4$)

• The trial balance is a control device listing all accounts and their respective balances to verify that Total Debits $=$ Total Credits.
• Preparation Steps:
  1. List titles in numerical order.
  2. Obtain balances from the ledger.
  3. Add the columns.
  4. Compare the totals.
• Trial Balance Totals for Weddings "R" Us as of May $31, 2021$:
  • Total Debits: $P586,800$
  • Total Credits: $P586,800$

Error Identification and Correction

Inequality in the trial balance signals an error. Common errors include:

1. Posting errors: Wrong amounts, debits/credits swapped, or omissions.
2. Balance errors: Mistakes in computing the T-account balance or entering it in the wrong column.
3. Trial Balance errors: Incorrectly adding columns, copying an amount wrong, or skipping an account.

Efficient Approaches to Locate Errors

1. Opposite Addition: Re-add columns in the opposite direction.
2. Determine Discrepancy:
   • Divisibility by $9$: If the difference is divisible by $9$, check for Transposition (e.g., $P21,750$ written as $P21,570$) or a Slide (e.g., swapping decimals like $P21,750.00$ as $P2,175.00$).
   • Scan for Half-Discrepancy: If a debit was recorded as a credit, the discrepancy is double the amount. Scan for an account balance equal to half the difference.
   • Look for Exact Difference: The error might be a forgotten singular entry (one side of a transaction).
3. Comparison: Compare trial balance amounts to ledger balances.
4. Re-compute: Verify the math in the ledger accounts.
5. Trace Postings: Re-verify every entry from the journal to the ledger, check-marking as you go.

Undetected Errors

A balanced trial balance does not catch:

• Failure to record a transaction entirely.
• Double-posting a transaction.
• Entries with the same erroneous debit and credit amount.
• Posting to the correct side (debit/credit) but the wrong account.