Chapter 2
Analyzing
Business
Transactions
Skyline College
Measuring Transactions
Economic Event
When to
record?
What value
to record?
How to
categorize?
Recognition
Valuation
Classification
Affects the financial position of an entity
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2–2
When is a Recognized?
Recognition of a transaction refers to
when it should be recorded
Point of recognition is important because
it affects the financial statements
For Products
For Services
 Recognize when title
of property transfers
 Recognize when services
are performed
 If services are performed
over a long period of time,
bill at key points
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2–3
At What Value Should a Transaction
Be Recorded?
 GAAP state that original cost (historical cost) be used to
assign value
 The cost principle is used because the exchange price can
be verified by documentation (a cancelled check or an
invoice)
Check 334:
Intelligent Designs
$1,500 for computer
Record at cost = $1,500
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2–4
How Should a Transaction Be Classified?
 Classification refers to assigning
transactions to the proper accounts
 Requires maintaining a system of
accounts
©Comstock Klips
Able Co. purchases tools used for repairing
manufacturing equipment.
Classify as
an expense
OR
Affects net income
(stockholders’ equity)
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Classify as
equipment
Affects assets
2–5
Ethics and Measurement Issues
In the News – Violations of Measurement Guidelines
Xerox overstates revenues: Records lease revenues
when leases signed rather than over lease term
Enron overvalues assets:
Investors and employees lose
billions
WorldCom misclassifies
expenditures: Understates
expenses by more than
$10 billion
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© Royalty-Free/Corbis
2–6
Discussion: Ethics on the Job
Curt Winthrop, CFO for Tralcom Industries,
decided to classify a purchase of small tools
as an asset rather than an expense. In the past,
such purchases have been classified as
expenses, but the company needs the income
statement to look strong for an upcoming
loan application.
Q. What do you think of Winthrop’s decision?
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2–7
The Backbone of Accounting
Based on the principle of duality – Every
economic event has two aspects…
Effort
Sacrifice
AND
AND
Reward
Benefit
In the double-entry accounting system,
every transaction is recorded with at least…
One Debit
AND
One Credit
Debit totals must equal credit totals
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2–8
Sacrifice Versus Benefit
If you were to
purchase a HD DVD
player for $300, what
is your sacrifice?
What is your benefit?
Sacrifice = $300
Benefit = DVD player
© Royalty-Free/Corbis
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2–9
Accounts
Basic storage units for accounting data
Used to accumulate amounts from similar
transactions
Categories of Accounts
Assets
Liabilities
Stockholders’
Equity
• Common Stock
• Retained Earnings
+ Revenues
- Expenses
- Dividends
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2–10
The T Account
The T account is a visual representation of an account
Used to analyze transactions
Identifies the asset,
liability, or
stockholders’ equity
account
Title of Account
Debit
(left) side
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Credit
(right) side
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2–11
The Rules of Double-Entry
Accounting
 Remember that every transaction affects at least
two accounts.
 At least one account is debited and one account is
credited. One on the left and one on the right.
Assets
Debit
for
Increases
(+)
=
Credit
for
Decreases
(–)
Liabilities
Debit
Credit
for
for
Decreases Increases
(–)
(+)
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+
Stockholders’
Equity
Debit
for
Decreases
(–)
Credit
for
Increases
(+)
2–12
Stockholders’ Equity Accounts
Increases to these accounts increase
stockholders’ equity:
Common Stock
–
+
Retained Earnings
–
+
Revenues
–
These accounts are
deductions from
stockholders’ equity:
Dividends
+
–
Expenses
+
+
–
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2–13
Normal Balance of Account
The usual balance of an account
The side (debit or credit) that increases an
account
Account
Normal balance of
asset, dividend,
and expense accounts
Normal balance of
liability, common stock,
retained earnings, and
revenue accounts
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Debit
side
Account
Credit
side
2–14
Accounts and the Accounting
Equation Illustrated
If a debit increases assets by $100, then a credit must
increase stockholders’ equity or liabilities by $100 for the
accounting equation to stay in balance.
Assets
+
=
_
Liabilities
_
700
100
800
+
_
+
200
100
=
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300
Stockholders’
Equity
+
500
+
500
2–15
Analyzing and Recording
Transactions
1. Analyze the transaction to
determine which accounts are
affected.
2. Show the transaction in
journal form.
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3. Use T accounts to show how
the transaction affects the
accounting equation.
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2–16
Transaction: Owner’s Investment
July 1: Pricilla Treadle invests $40,000 in Treadle
Website Design, Inc. in exchange for 40,000 shares of
$1 par value common stock.
Assets
=
Liabilities
+
Cash
+
+
40,000
Stockholders’
Equity
Common Stock
+
+
40,000
Next: Record the entry in journal form
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2–17
Transaction: Journal Form
Recording the transaction in journal form:
1. Date recorded on first line
2. Debit account and debit amount
recorded on first line
3. Indent, credit account and credit
amount recorded on second line
Dr.
July 1
Cash
Common Stock
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Cr.
40,000
40,000
2–18
Transaction: Prepayment of Rent
July 3: Payment of 2 months rent in advance, $3,200
Assets
=
Liabilities
+
Stockholders’
Equity
Cash
+
40,000
3,200
Prepaid Rent
+
3,200
-
This transaction simply
trades one asset for another.
The amount of total assets
is not changed.
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2–19
Transaction: Journal Form
Recording the
transaction in
journal form:
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July 3 Prepaid Rent
Cash
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Dr.
3,200
Cr.
3,200
2–20
Transaction: Purchase of
Supplies on Credit
July 5: Receipt of office supplies ordered on July 2 and
an invoice for $5,200.
Assets
=
Office Supplies
+
5,200
July 5
Liabilities
+
Stockholders’
Equity
Accounts Payable
-
-
+
5,200
Office Supplies
Accounts Payable
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5,200
5,200
2–21
Transaction: Service Revenue
July 15: Performs design services; bill now but to be received
later, $9,600
Assets
=
Liabilities
Accounts Receivable
+
9,600
July 15
Stockholders’
Equity
+
Design Revenue
-
-
Accounts Receivable
Design Revenue
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+
9,600
9,600
9,600
2–22
Preparing the Trial Balance
 To ensure that total debits equal total credits,
prepare a trial balance
 Usually prepared on the last day of month
1. List accounts in the order in which they
appear on the financial statements.
2. Put debit balances in the left column and
credit balances in the right column
3. Add each column.
4. Compare the totals of the columns.
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2–23
Trial Balance
Treadle Website Design, Inc.
Trial Balance
July 31, 20xx
Cash
$22,480
Accounts Receivable
4,600
Office Supplies
5,200
Prepaid Rent
3,200
Office Equipment
16,320
Accounts Payable
Unearned Design Revenue
Common Stock
Dividends
2,800
Design Revenue
Wages Expense
4,800
Utilities Expense
680
$60,080
Record debit
balances in left
column
$ 6,280
1,400
40,000
12,400
$60,080
Total each column
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Record credit
balances in right
column
2–24
Finding Trial Balance Errors
If the debit and credit totals are not equal, look for
one or more of these errors:
[photo]
© Royalty-Free/Corbis
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 A debit was entered as a
credit, or vice versa
 The balance of an account
was computed incorrectly
 An error was made in
carrying the account
balance to the trial balance
 The trial balance was
summed incorrectly
2–25
What Are the Most Common Trial
Balance Errors?
 Recording a debit as a
credit or vice versa
Hint:
The trial
balance will
be out of
balance by an
amount
divisible by 2
 Transposing two digits
when transferring an
amount to the trial balance
Hint:
The trial
balance will be
out of balance
by an amount
divisible by 9
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2–26
Limitations of the Trial Balance
 Does not prove that
transactions were
analyzed correctly
 Does not determine
whether amounts
were recorded in
the proper accounts
[Photo]
© Royalty Free PhotoDisc Collection/ Getty Images
 Does not detect whether transactions have been
omitted
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2–27
Cash Flows: Treadle Website
Design, Inc.
Cash
+
Inv. by owner
40,000
Revenue
2,800
Advance revenue 1,400
Collection of A/R 5,000
Bal.
_
3,200
13,320
2,600
4,800
2,800
Prepayment of rent
Purchase of equipment
Payment of liability
Payment of wages
Payment of dividends
22,480
Treadle must ensure that it has adequate cash on hand
at all times to pay its debts and maintain ongoing
operations.
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2–28
Accounting System
General Ledger
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Squared Studios/
Getty Images
100 Account
300 Account
101 Account
301 Account
200 Account
System of
accounts
grouped
together
manually or
electronically
400 Account
Chart of
Accounts
List of accounts
and identifying
numbers
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2–29
Sample Chart of Accounts
Assets
Assets
The first digit
in each account
number
signifies its
classification
Revenues
100
Cash
401
Service A
102
Accounts Receivable
402
Service B
105
Office Supplies
403
Service C
106
Prepaid Rent
110
Land
Liabilities
Liabilities
Expenses
200
Accounts Payable
501
Wages Expense
201
Notes Payable
502
Utilities Expense
204
Wages Payable
503
Rent Expense
504
Office Supplies Expense
505
Income Taxes Expense
Stockholders’Equity
Equity
Stockholders’
301
Common Stock
305
Retained Earnings
313
Dividends
314
Income Summary
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2–30
The General Journal
Journalizing is the process of recording all
transactions chronologically in a journal
General Journal: Most flexible and simple
General Journal
Date
Description
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Page 1
Post.
Ref.
Debit
Credit
2–31
Journalizing a Transaction
July 6 Purchased cleaning supplies and office supplies on account
Record: 1. The date
2. Names of accounts debited and dollar amounts on same
line in debit column
3. Names of accounts credited (indented) and dollar
amounts on same line in credit column
4. Explanation of transaction
5. Account identification numbers, if applicable
General Journal
Date
20xx
July 6
Description
Cleaning Supplies
Office Supplies
Accounts Payable
Purchased supplies on credit
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Page 1
Post.
Ref.
Debit
Credit
1,800
800
2,600
2–32
The General Ledger
 Used to record the
details of each
transaction
 In practice, the ledger
account form is used
 Used to update each
account
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General Ledger
Account Name
Date
Item
Post.
Ref.
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Debit
Credit
Account No.
Balance
Debit
Credit
2–33
Ledger Account Form
General Ledger
Accounts Payable
Date
Item
Post.
Ref.
Debit
Credit
Account No. 212
Balance
Credit
Debit
 Account title and number appear at top of account form
 The date appears in the first two columns (as in the journal)
 Item column is rarely used because explanations already appear in
the journal
 Post. Ref. column used to note the journal page on which the original
entry for the transaction can be found
 Dollar amount is entered in appropriate Debit or Credit column
 New account balance computed in the last two columns opposite each entry
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2–34
Posting
Transferring…
Journal entry
information
transferred
from the
journal
to
the ledger
Posting can be done daily, or less frequently
depending on the number of transactions
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2–35
Posting a Transaction
General Journal
Date
20xx
July
Page 2
Post.
Ref.
Description
30 Telephone Expense
Accounts Payable
Received bill from telephone
company
Debit
Credit
140
513
140
General Ledger
Accounts Payable
Date
20xx
July
Item
5
6
9
30
Post.
Ref.
J1
J1
J1
J2
Debit
Credit
Account No. 212
Balance
Debit
Credit
1,500
2,600
1,500
4,100
3,100
3,240
1,000
140
General Ledger
Telephone Expense
Date
20xx
July 30
Item
Post.
Ref.
J2
Debit
Credit
140
Account No. 513
Balance
Debit
Credit
140
1. Locate debit account in the
ledger
2. Enter date of transaction
and journal page number in
Post. Ref. column
3. Enter in Debit column
amount of debit from
journal
4. Calculate account balance
and enter in appropriate
Balance column
5. In journal Post. Ref.
Column, enter account
number to which amount
was posted
6. Repeat for credit entry
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2–36