2-1
Financial Statements and the
Accounting System
Chapter 2
John J. Wild
Financial Accounting: Information for
Decisions
9th Edition
Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Chapter 2 Learning Objectives
CONCEPTUAL
C1 Explain the steps in processing transactions and the role of source documents.
C2 Describe an account and its use in recording transactions.
C3 Describe a ledger and a chart of accounts.
C4 Define debits and credits and explain double-entry accounting.
ANALYTICAL
A1 Analyze the impact of transactions on accounts and financial statements.
A2 Compute the debt ratio and describe its use in analyzing financial condition.
PROCEDURAL
P1 Record transactions in a journal and post entries to a ledger.
P2 Prepare and explain the use of a trial balance.
P3 Prepare financial statements from business transactions.
© McGraw-Hill Education.
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1-3
Learning Objective C1
Explain the steps in processing
transactions and the role of
source documents.
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2-2
1-4
Basics of Financial Statements
Business transactions and events are the starting points of
Click to edit Master text styles
financial statements. Process from transactions to financial
Second
level
statements
is as
follows:
Third level
• Identify each transaction and event from source documents.
• Analyze each transaction and event using the accounting
equation.
• Record relevant transactions and events in a journal.
• Post journal information to ledger accounts.
• Prepare and analyze the trial balance and financial
statements.
© McGraw-Hill Education
Learning O bjective C1: E xplain the steps in processing transactions and the role of source docum ents.
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Source Documents
Source documents identify and describe
transactions entering the accounting system.
Examples:
• Bills from Suppliers
• Sales tickets
• Checks
• Purchase Orders
• Employee Earnings Records
• Bank Statements
© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
Learning O bjective -C1: E xplain the steps in processing transactions and the role of source docum ents.
© McGraw-Hill
Education
reproduction
or further distribution permitted without the prior written consent of McGraw-Hill
Education.
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Learning Objective C2
Describe an account and its use in
recording transactions.
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2-3
1-7
The Account Underlying Financial
Statements
An account is a
record of
increases and
decreases in a
specific asset,
liability, equity,
revenue, or
expense.
The general
ledger is a record
of all accounts
used by the
company.
© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
Learning O bjective C2: D escribe an account and its use in recording transactions.
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Education
reproduction
or further distribution permitted without the prior written consent of McGraw-Hill
Education.
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1-8
The Account and Its Analysis
Exhibit
2.1
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Learning O bjective C2: D escribe an account and its use in recording transactions.
© McGraw-Hill
Education
reproduction
or further distribution permitted without the prior written consent of McGraw-Hill
Education.
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1-9
Asset Accounts
Cash
Land
Buildings
Asset
Accounts
Accounts
Receivable
Notes
Receivable
Prepaid
Accounts
Equipment
Supplies
Learning O bjective C2: D escribe an account and its use ©
in recording
transactions.
McGraw-Hill
Education.
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© McGraw-Hill Education
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2-4
Liability Accounts
Accounts
Payable
Notes
Payable
Liability
Accounts
Accrued
Liabilities
Unearned
Revenue
© McGraw-Hill Education
Learning O bjective C2: D escribe an account and its use in recording transactions.
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Equity Accounts
+
Common
stock
Dividends
Equity
Accounts
+
Revenues
Learning O bjective C2: D escribe an account and its use in recording transactions.
Expenses
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Expanded Accounting Equation
Revenues and common stock increases equity.
Expenses and dividends decrease equity.
Learning O bjective C2: D escribe an account and its use in recording transactions.
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© McGraw-Hill Education 12
2-5
Learning Objective C3
Describe a ledger and chart of
accounts.
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Ledger and Chart of Accounts
The ledger is a collection of all accounts and their
balances for an accounting system. A company’s
size and diversity of operations affect the number
of accounts needed.
The chart of accounts is a list of all accounts and includes an
identifying number for each account.
Exhibit
2.4
Learning O bjective C3: D escribe a ledger and chart of accounts.
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NEED-TO-KNOW 2-1
Classify each of the following as assets (A), liabilities (L), or equity (EQ).
1)
2)
3)
4)
5)
6)
7)
8)
9)
10)
11)
12)
(A) Asset
(EQ) Equity
(A) Asset
(L) Liability
(A) Asset
(A) Asset
(L) Liability
(L) Liability
(A) Asset
(A) Asset
(L) Liability
(L) Liability
Prepaid Rent
Assets – Things of value owned by the company.
Liabilities – Amounts owed to creditors.
Common Stock
Equity – The residual interest (Assets – Liabilities)
Note Receivable
Accounts Payable
Accounts Receivable
Equipment
Interest Payable
Unearned Revenue
Land
Prepaid Insurance
Wages Payable
Rent Payable
Key words to look for in account titles:
Prepaid
Receivable
Payable
Unearned
Always
Always
Always
Always
an asset
an asset
a liability
a liability
Learning O bjective C1: E xplain the steps in processing transactions and the role of source docum ents.
Learning O bjective C2: D escribe an account and its use in recording transactions.
Learning O bjective C3: D escribe a ledger and chart of accounts .
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© McGraw-Hill Education
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2-6
Learning Objective C4
Define debits and credits and
explain double-entry
accounting.
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Debits and Credits
A T-account represents a ledger account
and is used to show the effects of one or
more transactions.
Exhibit
2.5
© McGraw-Hill Education
Learning O bjective C4: D efine debits and credits and explain double -entry accounting.
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Double-Entry Accounting
Assets
=
Liabilities
+
Equity
Exhibit
2.6
Learning O bjective C4: D efine debits and credits and explain double -entry accounting.
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© McGraw-Hill Education
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2-7
Double-Entry Accounting:
Expanded Accounting Equation
Here is the expanded accounting equation
Exhibit
showing the equity section.
2.7
© McGraw-Hill Education
Learning O bjective C4: D efine debits and credits and explain double -entry accounting.
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Double-Entry Accounting:
Account Balance
An account balance is the difference between the increases and
decreases in an account. Notice the T-Account.
Exhibit
2.8
© McGraw-Hill Education
Learning O bjective C4: D efine debits and credits and explain double -entry accounting.
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NEED-TO-KNOW 2-2
Identify the normal balance (debit [Dr] or credit [Cr]) for each of the following accounts.
1)
Dr. Debit
Prepaid Rent
2)
Cr. Credit
Common Stock
3)
Dr. Debit
Note Receivable
4)
Cr. Credit
Accounts Payable
5)
Dr. Debit
Accounts Receivable
6)
Dr. Debit
Equipment
7)
Cr. Credit
Interest Payable
8)
Cr. Credit
Unearned Revenue
9)
Dr. Debit
Land
10)
Dr. Debit
Prepaid Insurance
11)
Dr. Debit
Dividends
12)
Dr. Debit
Utilities Expense
Assets
Increase Decrease
Debits
Credits
Normal
=
Liabilities
Decrease
Increase
Debits
Credits
+
Equity
Decrease Increase
Debits
Credits
D ividends
E xpenses
Normal
Dividends
↓ Equity
D ividends
Normal
Expenses
↓ Equity
E xpenses
Normal
Learning O bjective C4: D efine debits and credits and explain double -entry accounting.
21
C om m on S tock
R evenues
Common Stock
↑ Equity
C om m on S tock
Normal
Revenues
↑ Equity
R evenues
Normal
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© McGraw-Hill Education
2-8
Learning Objective P1
Record transactions in a
journal and post entries to a
ledger.
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Journalizing and Posting
Transactions
Learning O bjective P1: R ecord transactions in a journal and post entries to a ledger.
Exhibit
2.9
© McGraw-Hill Education
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Journalizing Transactions
a.
Transaction
Date
d. Transaction
explanation
b. Titles of Affected
Accounts
c.
Dollar amount of debits
and credits
Learning O bjective P1: R ecord transactions in a journal and post entries to a ledger.
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Exhibit
2.10
© McGraw-Hill Education
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2-9
Balance Account Column
Exhibit
2.11
T-accounts are useful illustrations, but balance
column ledger accounts are used in practice.
Learning O bjective P1: R ecord transactions in a journal and post entries to a ledger.
© McGraw-Hill Education
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Posting Journal Entries
Learning O bjective P1: R ecord transactions in a journal and post entries to a ledger.
Exhibit
2.12
© McGraw-Hill Education
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Learning Objective A1
Analyze the impact of
transactions on accounts and
financial statements.
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2-10
Processing Transactions
Double-entry accounting is useful in analyzing and
processing transactions. Analysis of each transaction
follows these four steps.
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education
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Processing Transactions #1
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education
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Processing Transactions #2
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
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© McGraw-Hill Education
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2-11
Processing Transactions #3
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education
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Processing Transactions #4
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education
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Processing Transactions #5
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
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© McGraw-Hill Education 33
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2-12
Processing Transactions #6
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education 34
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Processing Transactions #7
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education 35
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Processing Transactions #8
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
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© McGraw-Hill Education 36
2-13
Processing Transactions #9
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education 37
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Processing Transactions #10
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education 38
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Processing Transactions #11
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
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© McGraw-Hill Education 39
2-14
Processing Transactions #12
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education 40
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Processing Transactions #13
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education 41
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Processing Transactions #14
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
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© McGraw-Hill Education 42
2-15
Processing Transactions #15
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education 43
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Processing Transactions #16
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education 44
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Summarizing Transactions
in a Ledger
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
45
Exhibit
2.13
© McGraw-Hill Education 45
2-16
NEED-TO-KNOW 2-3
Assume Tata began operations on January 1 and completed the following transactions during its first month of
operations.
Jan. 1
Jan. 5
Jan. 14
Jamsetji invested $4,000 cash in the Tata company in exchange for its common stock.
The company purchased $2,000 of equipment on credit.
The company provided $540 of services for a client on credit.
For each transaction, (a) analyze the transaction using the accounting equation, (b) record the transaction in
journal entry form, and c) post the entry using T-accounts to represent the general ledger accounts.
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
© McGraw-Hill Education
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NEED-TO-KNOW 2-3 – Answers January 1
Jan. 1
Jamsetji invested $4,000 cash in the Tata company in exchange for its common stock.
a) Analyze
Assets = Liabilities + Equity
+ $4,000
+ $4,000
b) Record
Date
Jan. 1
General Journal
Cash
Common Stock
c) Post
Debit
4,000
Credit
4,000
Cash
Jan. 1
4,000
Common Stock
Jan. 1
Assets
Increase Decrease
Debits
Credits
=
Normal
Liabilities
Decrease
Increase
Debits
Credits
4,000
+
Equity
Decrease Increase
Debits
Credits
D ividends
E xpenses
Normal
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
C om m on S tock
R evenues
© McGraw-Hill Education
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NEED-TO-KNOW 2-3 - Answers January 5
Jan. 5
The company purchased $2,000 of equipment on credit.
a) Analyze
Assets = Liabilities + Equity
+ $2,000
+ $2,000
b) Record
Date
Jan. 5
c) Post
Jan. 5
General Journal
Equipment
Accounts Payable
Normal
=
2,000
Liabilities
Decrease
Increase
Debits
Credits
2,000
+
Normal
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
48
Credit
Equipment
2,000
Accounts Payable
Jan. 5
Assets
Increase Decrease
Debits
Credits
Debit
2,000
Equity
Decrease Increase
Debits
Credits
D ividends
E xpenses
C om m on S tock
R evenues
© McGraw-Hill Education
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2-17
NEED-TO-KNOW 2-3 - Answers January 14
Jan. 14
The company provided $540 of services for a client on credit.
a) Analyze
Assets = Liabilities + Equity
+ $540
+ $540
b) Record
Date
Jan. 14
c) Post
Jan. 14
General Journal
Accounts Receivable
Services Revenue
=
Credit
540
Accounts Receivable
540
Services Revenue
Jan. 14
Assets
Increase Decrease
Debits
Credits
Debit
540
Liabilities
Decrease
Increase
Debits
Credits
Normal
540
+
Normal
Learning O bjective A1: A nalyze the im pact of transactions on accounts and financial statem ents.
Equity
Decrease Increase
Debits
Credits
D ividends
E xpenses
C om m on S tock
R evenues
© McGraw-Hill Education
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Learning Objective P2
Prepare and explain the
use of a trial balance.
© McGraw-Hill Education 50
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Preparing a Trial Balance
Preparing a trial balance has three steps:
1. List each account title and its amount (from ledger) in
the trial balance. If an account has a zero balance, list it
with a zero in the normal balance column (or omit it
entirely).
2. Compute the total of debit balances and the total of
credit balances.
3. Verify (prove) total debit balances equal total credit
balances.
Learning O bjective P2: P repare and explain the use of a trial balance.
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© McGraw-Hill Education 51
2-18
FastForward’s Trial Balance
The trial
balance lists
all ledger
accounts and
their balances
at a point in
time. If the
books are in
balance, the
total debits
will equal the
total credits.
© McGraw-Hill Education 52
Learning O bjective P2: P repare and explain the use of a trial balance.
52
Searching for Errors
If the trial balance does not balance, the error(s)
must be found and corrected.
ΠMake sure the trial
 Recompute each
balance columns are
account balance in the
correctly added.
ledger.
 Make sure account
balances are correctly
entered from the ledger.
 Verify that each journal
entry is posted correctly.
Ž See if debit or credit
accounts are mistakenly
placed on the trial balance.
‘ Verify that each
original journal entry has
equal debits and credits.
Learning O bjective P2: P repare and explain the use of a trial balance.
© McGraw-Hill Education 53
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Financial Statements
Prepared from Trial Balance
Exhibit
2.15
Learning O bjective P3: P repare financial statem ents from business transactions.
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© McGraw-Hill Education 54
2-19
Learning Objective P3
Prepare financial statements
from business transactions.
© McGraw-Hill Education 55
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Financial Statements
The four financial statements and their purposes are:
1. Income statement — reports revenues less expenses incurred by a
business over a period of time.
2. Statement of retained earnings— reports how equity changes over the
reporting period from net income (or loss) and from any owner investments
and withdrawals over a period of time.
3. Balance sheet — reports the financial position (types and amounts of
assets, liabilities, and equity) at a point in time.
4. Statement of Cash Flows — The statement of cash flows lists the cash
inflows and cash outflows for the period.
**For simplicity, we do not show the statement of cash flows for FastForward in this
chapter, but we do return to this statement in the next chapter.**
Learning O bjective P3: P repare financial statem ents from business transactions.
© McGraw-Hill Education 56
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Income Statement
Learning O bjective P3: P repare financial statem ents from business transactions.
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Exhibit
2.16
© McGraw-Hill Education 57
2-20
Statement of Retained Earnings
Exhibit
2.16
Learning O bjective P3: P repare financial statem ents from business transactions.
© McGraw-Hill Education 58
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Balance Sheet
Learning O bjective P3: P repare financial statem ents from business transactions.
Exhibit
2.16
© McGraw-Hill Education 59
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Presentation Issues
1. Dollar signs are not used in journals and ledgers.
2. Dollar signs appear in financial statements and other
reports such as trial balances. Put dollar signs beside
only the first and last numbers in a column.
3. When amounts are entered in the journal, ledger, or
trial balance, commas are optional to indicate
thousands, millions, and so forth.
4. Commas are always used in financial statements.
5. Companies commonly round amounts in reports to the
nearest dollar, or even to a higher level.
Learning O bjective P3: P repare financial statem ents from business transactions.
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2-21
NEED-TO-KNOW 2-4
Prepare a trial balance for Apple using the following condensed data from its fiscal year-ended
September 24, 2016.
Common stock
Accounts payable
Other liabilities
Cost of sales (expense)
Cash
Revenues
Dividends
$27,071
37,294
156,143
131,376
20,484
215,639
40,628
Investments and other assets $258,438
Land and equipment (net)
27,010
Selling and other expense
38,576
Accounts receivable
15,754
Retained earnings, beg. of year 91,939
APPLE
Trial Balance
September 24, 2016
Debit
Normal
Assets
Assets
Increase Decrease
Debits
Credits
Credit
Liabilities
Normal
Common Stock
Normal
Retained Earnings
Normal
Dividends
Normal
Liabilities
Decrease
Increase
Debits
Credits
Normal
Normal
Revenues
Normal
Expenses
Normal
Totals
Debits = Credits
Equity
Decrease Increase
Debits
Credits
D ividends
E xpenses
Learning O bjective P2: P repare and explain the use of a trial balance.
C om m on S tock
R evenues
© McGraw-Hill Education
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NEED-TO-KNOW 2-4 - Answers
Prepare a trial balance for Apple using the following condensed data from its fiscal year-ended
September 24, 2016.
Common stock
Accounts payable
Other liabilities
Cost of sales (expense)
Cash
Revenues
Dividends
Assets
Increase Decrease
Debits
Credits
Normal
Liabilities
Decrease
Increase
Debits
Credits
Normal
Equity
Decrease Increase
Debits
Credits
D ividends
E xpenses
C om m on S tock
R evenues
$27,071
37,294
156,143
131,376
20,484
215,639
40,628
Investments and other assets $258,438
Land and equipment (net)
27,010
Selling and other expense
38,576
Accounts receivable
15,754
Retained earnings, beg. of year 91,939
APPLE
Trial Balance
September 24, 2016
Debit
Cash
$20,484
Accounts receivable
15,754
Land and equipment (net)
27,010
Investments and other assets
258,438
Accounts payable
Other liabilities
Common stock
Retained earnings, beg. of year
Dividends
40,628
Revenues
Cost of sales (expense)
131,376
Selling and other expense
38,576
Totals
$532,266
Learning O bjective P2: P repare and explain the use of a trial balance.
Credit
$37,294
156,143
27,071
91,939
215,639
$532,266
© McGraw-Hill Education
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Learning Objective A2
Compute the debt ratio and
describe its use in analyzing
financial condition.
© McGraw-Hill Education 63
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2-22
Debt Ratio - Equation
Debt Ratio =
Total Liabilities
Total Assets
Evaluates the level of debt risk.
A higher ratio indicates that there is a
greater probability that a company will
not be able to pay its debt in the future.
Learning O bjective A2: C om pute the debt ratio and describe its use in analyzing financial condition.
© McGraw-Hill Education
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Debt Ratio - Computation
Debt Ratio =
Total Liabilities
Total Assets
Exhibit
2.18
Learning O bjective A2: C om pute the debt ratio and describe its use in analyzing financial condition.
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End of Chapter 2
© McGraw-Hill Education
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