chapter 2 financial accounting

Analyzing Analyzing

TransactionsTransactions

Chapter 2Chapter 2Chapter 2Chapter 2

Learning ObjectivesLearning Objectives

1.1. Describe the characteristics of an account and a Describe the characteristics of an account and a chart of accounts.chart of accounts.

2.2. Describe and illustrate journalizing transactions Describe and illustrate journalizing transactions using the double-entry accounting system.using the double-entry accounting system.

3.3. Describe and illustrate the journalizing and Describe and illustrate the journalizing and posting of transactions to accounts.posting of transactions to accounts.

4.4. Prepare an unadjusted trial balance and explain Prepare an unadjusted trial balance and explain how it can be used to discover errors.how it can be used to discover errors.

5.5. Describe and illustrate the use of horizontal Describe and illustrate the use of horizontal analysis in evaluating a company’s performance analysis in evaluating a company’s performance and financial condition.and financial condition.

Learning Learning Objective

ObjectiveDescribe the characteristics of

Describe the characteristics of

an account and a chart of

an account and a chart of accounts.accounts.

Using Accounts to Record TransactionsUsing Accounts to Record Transactions

o Accounting systems are designed to show Accounting systems are designed to show the increases and decreases in each the increases and decreases in each accounting equation element as a accounting equation element as a separate record. This record is called an separate record. This record is called an accountaccount..

USING USING ACCOUNTS TO ACCOUNTS TO

RECORD RECORD TRANSACTIONSTRANSACTIONS

THE T THE T ACCOUNTACCOUNT

The T account has a title

The left side of the account is called the debitdebit

The right side of the account is

called the creditcredit side.

Credit

Cash(a) 25,000 (b) 20,000(d) 7,500 (e) 3,650

(f) 950(h) 2,000

Balance 5,900

Debit Side of Account

Credit Side of Account

Balance of the account

Chart of AccountsChart of Accounts

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

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

o AssetsAssets are resources owned by the are resources owned by the business. Some examples of assets follow:business. Some examples of assets follow: CashCash

SuppliesSupplies

Accounts receivableAccounts receivable

BuildingsBuildings

CopyrightsCopyrights

TrademarksTrademarksIntangible assetsIntangible assets

o LiabilitiesLiabilities are debts owed to outsiders are debts owed to outsiders (creditors). Some examples of liabilities (creditors). Some examples of liabilities follow:follow: Accounts payableAccounts payable

Notes payableNotes payable

Wages payableWages payable

Interest payableInterest payable

o Stockholders’ equityStockholders’ equity is the stockholders’ is the stockholders’ right to the assets of the business after all right to the assets of the business after all liabilities have been paid. Stockholders’ liabilities have been paid. Stockholders’ equity is represented by the balance of equity is represented by the balance of the capital stock and retained earnings the capital stock and retained earnings accounts.accounts.

o A A dividendsdividends account represents account represents distributions of earnings to stockholders.distributions of earnings to stockholders.

o RevenuesRevenues are increases in stockholders’ are increases in stockholders’ equity as a result of selling services or equity as a result of selling services or products to customers. Some examples of products to customers. Some examples of revenue accounts are:revenue accounts are: Fees earnedFees earned

Commission revenueCommission revenue

Rent revenueRent revenue

o The using up of assets or consuming The using up of assets or consuming services in the process of generating services in the process of generating revenues results in revenues results in expensesexpenses. Some . Some examples of expenses follow:examples of expenses follow: Wages expenseWages expense

Rent expenseRent expense

Miscellaneous expenseMiscellaneous expense

CHART OF CHART OF ACCOUNTSACCOUNTS

ObjectiveDescribe and illustrate

Describe and illustrate

journalizing transactions using

the double-entry accounting

the double-entry accounting system.system.

Double-Entry Accounting SystemDouble-Entry Accounting System

o All businesses use what is called the All businesses use what is called the double-entry accounting systemdouble-entry accounting system. This . This system is based on the accounting system is based on the accounting equation and requires:equation and requires: Every business transaction to be recorded in at Every business transaction to be recorded in at

least two accounts.least two accounts.

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

Balance Sheet AccountsBalance Sheet Accounts

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

Income Statement AccountsIncome Statement Accounts

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

DividendsDividends

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

Normal BalancesNormal Balances

o The sum of the increases in an account is The sum of the increases in an account is usually equal to or greater than the sum usually equal to or greater than the sum of the decreases in the account. Thus, the of the decreases in the account. Thus, the normal balance ofnormal balance of an accountan account is either a is either a debit or a credit depending on whether debit or a credit depending on whether increases in the account are recorded as increases in the account are recorded as debits or credits.debits or credits.

RULES OF DEBIT RULES OF DEBIT AND CREDIT – AND CREDIT –

NORMAL NORMAL BALANCES OF BALANCES OF

ACCOUNTSACCOUNTS

Normal BalancesNormal Balances

Increases (Normal Bal.) Decreases

Balance sheet accounts:AssetDebit CreditLiability Credit DebitStockholders’ Equity:

Capital Stock Credit DebitRetained Earnings Credit Debit

Income statement accounts:Revenue Credit DebitExpense DebitCredit

Transaction ATransaction A

o On November 1, Chris Clark deposited $25,000 in On November 1, Chris Clark deposited $25,000 in a bank account in the name of NetSolutions in a bank account in the name of NetSolutions in exchange for capital stock.exchange for capital stock.

TRANSACTION TRANSACTION AA

Assets = Liabilities + Stockholders’ Equity (investment)Assets = Liabilities + Stockholders’ Equity (investment)

ACCOUNTING EQUATION ACCOUNTING EQUATION IMPACTIMPACT

increase increase

Step 1

Step 2

Step 3

Step 3 Step 5Step 4

(continued)

JournalizingJournalizing

Journalizing requires the following steps:Journalizing requires the following steps:Step 1.Step 1. The date of the transaction is entered The date of the transaction is entered in the Date column.in the Date column.

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

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

(continued)

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

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

o A transaction is initially entered in a record A transaction is initially entered in a record called a called a journaljournal..

o A transaction is initially entered in a record A transaction is initially entered in a record called a journal.called a journal.

o The process of recording a transaction in The process of recording a transaction in the journal is called the journal is called journalizingjournalizing..

o A transaction is initially entered in a record A transaction is initially entered in a record called a journal.called a journal.

o The process of recording a transaction in The process of recording a transaction in the journal is called journalizing.the journal is called journalizing.

o The entry in the journal is called a The entry in the journal is called a journal journal entryentry..

Transaction BTransaction B

o On November 5, NetSolutions paid On November 5, NetSolutions paid $20,000 for the purchase of land as a $20,000 for the purchase of land as a future building site.future building site.

ACCOUNTING EQUATION IMPACTACCOUNTING EQUATION IMPACT

Assets = Liabilities + Stockholders’ EquityAssets = Liabilities + Stockholders’ Equity

increase

decrease

TRANSACTION TRANSACTION BB

Transaction CTransaction C

o On November 10, NetSolutions purchased On November 10, NetSolutions purchased supplies on account for $1,350.supplies on account for $1,350.

increase increase

TRANSACTION TRANSACTION CC

Transaction DTransaction D

o On November 18, NetSolutions received On November 18, NetSolutions received cash of $7,500 from customers for cash of $7,500 from customers for services provided.services provided.

Assets = Liabilities + Stockholders’ Equity (Revenue)Assets = Liabilities + Stockholders’ Equity (Revenue)

increase increase

TRANSACTION TRANSACTION DD

Transaction ETransaction E

o On November 30, NetSolutions incurred On November 30, NetSolutions incurred the following expenses: wages, $2,125; the following expenses: wages, $2,125; rent, $800; utilities, $450; and rent, $800; utilities, $450; and miscellaneous, $275. miscellaneous, $275.

Assets = Liabilities + Stockholders’ Equity (Expense)Assets = Liabilities + Stockholders’ Equity (Expense)

decrease

All four expense accounts increase

TRANSACTION TRANSACTION EE

Transaction FTransaction F

o On November 30, NetSolutions paid On November 30, NetSolutions paid creditors on account, $950. creditors on account, $950.

decreasedecrease

TRANSACTION TRANSACTION FF

Transaction GTransaction G

o NetSolutions purchased $1,350 of supplies NetSolutions purchased $1,350 of supplies on November 10. Chris Clark determined on November 10. Chris Clark determined that the cost of supplies on hand on that the cost of supplies on hand on November 30 was $550 or, stated another November 30 was $550 or, stated another way, $800 in supplies had been used. way, $800 in supplies had been used.

decrease increase

TRANSACTION TRANSACTION GG

Transaction HTransaction H

o On November 30, NetSolutions paid On November 30, NetSolutions paid $2,000 to stockholders (Chris Clark) as $2,000 to stockholders (Chris Clark) as dividends. dividends.

decrease increase

Assets = Liabilities + Stockholders’ Equity (Dividends)Assets = Liabilities + Stockholders’ Equity (Dividends)

TRANSACTION TRANSACTION HH

ObjectiveDescribe and illustrate

Describe and illustrate

journalizing and posting of

transactions to accounts.

Posting Journal Entries to AccountsPosting Journal Entries to Accounts

o The process of transferring the debits and The process of transferring the debits and credits from the journal entries to the credits from the journal entries to the accounts is called accounts is called postingposting..

Posting Journal Entries to AccountsPosting Journal Entries to Accounts

o On December 1, NetSolutions paid a On December 1, NetSolutions paid a premium of $2,400 for an insurance policy premium of $2,400 for an insurance policy for liability, theft, and fire. The policy for liability, theft, and fire. The policy covers a one-year period.covers a one-year period.

increase

decrease

POSTING POSTING JOURNAL JOURNAL

ENTRIES TO ENTRIES TO ACCOUNTSACCOUNTS

Steps in PostingSteps in Posting

o Step 1.Step 1. The The date of the date of the transaction is transaction is entered in the entered in the Date column Date column of Prepaid of Prepaid Insurance.Insurance.

o Step 2.Step 2. The The amount amount ($2,400) is ($2,400) is entered in the entered in the Debit column Debit column of Prepaid of Prepaid Insurance.Insurance.

o Step 3.Step 3. The The journal page journal page number (2) is number (2) is entered in the entered in the account’s account’s Post. Ref. Post. Ref. column.column.

o Step 4.Step 4. The The ledger ledger account account number (15) is number (15) is entered in the entered in the journal’s Post. journal’s Post. Ref. column.Ref. column.

December TransactionsDecember Transactions

o On December 1, NetSolutions paid rent for On December 1, NetSolutions paid rent for December, $800. The company from December, $800. The company from which NetSolutions is renting its store which NetSolutions is renting its store space now requires the payment of rent space now requires the payment of rent on the first of each month, rather than at on the first of each month, rather than at the end of the month. the end of the month.

decrease increase

DECEMBER DECEMBER TRANSACTIONSTRANSACTIONS

o On December 1, NetSolutions received an On December 1, NetSolutions received an offer from a local retailer to rent the land offer from a local retailer to rent the land purchased on November 5. purchased on November 5.

o The retailer plans to use the land as a The retailer plans to use the land as a parking lot for its employees and parking lot for its employees and customers. NetSolutions agreed to rent customers. NetSolutions agreed to rent the land to the retailer for three months, the land to the retailer for three months, with the rent payable in advance. with the rent payable in advance.

o NetSolutions received $360 for three NetSolutions received $360 for three months’ rent beginning December 1. months’ rent beginning December 1.

o The liability created by receiving the cash The liability created by receiving the cash in advance of providing the service is in advance of providing the service is called called unearned revenueunearned revenue. .

increaseincrease

o On December 4, NetSolutions purchased On December 4, NetSolutions purchased office equipment on account from office equipment on account from Executive Supply Co. for $1,800.Executive Supply Co. for $1,800.

increase increase

o On December 6, NetSolutions paid $180 On December 6, NetSolutions paid $180 for a newspaper advertisement.for a newspaper advertisement.

decrease increase

o On December 11, NetSolutions paid On December 11, NetSolutions paid creditors $400.creditors $400.

decrease decrease

o On December 13, NetSolutions paid a On December 13, NetSolutions paid a receptionist and a part-time assistant receptionist and a part-time assistant $950 for two weeks’ wages.$950 for two weeks’ wages.

decrease increase

o On December 16, NetSolutions received On December 16, NetSolutions received $3,100 from fees earned for the first half $3,100 from fees earned for the first half of December.of December.

increase increase

o Fees earned on account totaled $1,750 for Fees earned on account totaled $1,750 for the first half of December.the first half of December.

increase increase

o On December 20, NetSolutions paid $900 On December 20, NetSolutions paid $900 to Executive Supply Co. on the $1,800 to Executive Supply Co. on the $1,800 debt owed from the December 4 debt owed from the December 4 transaction.transaction.

decreasedecrease

o On December 21, NetSolutions received On December 21, NetSolutions received $650 from customers in payment of their $650 from customers in payment of their accounts.accounts.

LO 3LO 3

increase

decrease

o On December 23, NetSolutions paid On December 23, NetSolutions paid $1,450 for supplies.$1,450 for supplies.

increase

decrease

o On December 27, NetSolutions paid the On December 27, NetSolutions paid the receptionist and the part-time assistant receptionist and the part-time assistant $1,200 for two weeks’ wages.$1,200 for two weeks’ wages.

increasedecrease

o On December 31, NetSolutions paid its On December 31, NetSolutions paid its $310 telephone bill for the month.$310 telephone bill for the month.

increasedecrease

o On December 31, NetSolutions paid its On December 31, NetSolutions paid its $225 electric bill for the month.$225 electric bill for the month.

increasedecrease

o On December 31, NetSolutions received On December 31, NetSolutions received $2,870 from fees earned for the second $2,870 from fees earned for the second half of December.half of December.

increase increase

o On December 31, fees earned on account On December 31, fees earned on account totaled $1,120 for the second half of totaled $1,120 for the second half of December.December.

increase increase

o On December 31, paid dividends of On December 31, paid dividends of $2,000.$2,000.

increasedecrease

Assets = Liabilities + Stockholders’ Equity (Dividends)Assets = Liabilities + Stockholders’ Equity (Dividends)

LEDGER LEDGER NETSOLUTIONSNETSOLUTIONS

ObjectivePrepare an unadjusted trial

Prepare an unadjusted trial

balance and explain how it can

be used to discover errors.

Trial BalanceTrial Balance

o The equality of debits and credits in the The equality of debits and credits in the ledger should be proved at the end of ledger should be proved at the end of each accounting period by preparing a each accounting period by preparing a trial balancetrial balance..

UNADJUSTED UNADJUSTED TRIAL BALANCETRIAL BALANCE

Trial Balance Errors - TranspositionTrial Balance Errors - Transposition

o A A transpositiontransposition occurs when the order of occurs when the order of the digits is changed by mistake, such as the digits is changed by mistake, such as writing $542 as $452 or $524.writing $542 as $452 or $524.

Trial Balance Errors - SlideTrial Balance Errors - Slide

o In a In a slideslide, the entire number is moved one , the entire number is moved one or more spaces to the right or the left by or more spaces to the right or the left by mistake, such as writing $542.00 as mistake, such as writing $542.00 as $54.20 or $97.50 as $975.00.$54.20 or $97.50 as $975.00.

Errors Not Affecting the Trial BalanceErrors Not Affecting the Trial Balance

o If an error has already been journalized If an error has already been journalized and posted to the ledger, a and posted to the ledger, a correcting correcting journaljournal entryentry is normally prepared. is normally prepared.

o Another type of error is a posting error.Another type of error is a posting error.

o Assume that on May 5 a $12,500 purchase Assume that on May 5 a $12,500 purchase of office equipment on account was of office equipment on account was incorrectly journalized and posted as a incorrectly journalized and posted as a debit to supplies and a credit to accounts debit to supplies and a credit to accounts payable for $12,500.payable for $12,500.

o The entry to correct the error is:The entry to correct the error is:

ObjectiveDescribe and illustrate the use of

Describe and illustrate the use of

horizontal analysis in evaluating

a company’s performance and

a company’s performance and financial condition.

financial condition.

Horizontal AnalysisHorizontal Analysis

o In horizontal analysis, the amount of each In horizontal analysis, the amount of each item on a current financial statement is item on a current financial statement is compared with the same item on an compared with the same item on an earlier statement.earlier statement.

o When two statements are being When two statements are being compared, the earlier statement is used as compared, the earlier statement is used as the base for computing the amount and the base for computing the amount and the percent of change.the percent of change.

$3,000

$12,000= 25.0%

HORIZONTAL HORIZONTAL ANALYSISANALYSIS

Analyzing Analyzing

TransactionsTransactions

The EndThe EndThe EndThe End

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