Analyzing Business Transactions Chapter 2 Analyzing Business Transactions

Measurement Issues Objective 1 Explain how the concepts of recognition, valuation, and classification apply to business transactions and why they are important factors in ethical financial reporting.

Measuring Business Transactions Once you have determined that a transaction has occurred, you must decide: When the transaction occurred The recognition issue What value to place on the transaction The valuation issue How to categorize the components of the transaction The classification issue

Measurement Issues Recognition issue Valuation issue Classification issue These issues underlie almost every major decision in financial accounting Measurement issues are controversial

Recognition Recognition means the recording of a transaction Refers to the difficulty of deciding when a business transaction occurred Point of recognition is important because it affects the financial statements

Point of Recognition for Sales and Purchases Sales and purchases of products Usually recognized when title to merchandise passes from the supplier to the purchaser and creates an obligation to pay Or, may set up a recognition point Predetermined time at which a transaction should be recorded

Economic Events Events that are not recorded as transactions Events that are recorded as transactions Customer buys a service Customer inquires about a service Receiving products previously ordered Ordering products from suppliers Paying employees for work performed Hiring new employees

Valuation Focuses on assigning a monetary value to a transaction Most controversial issue in accounting According to GAAP, use original cost Also called historical cost Practice of recording transactions at cost follows the cost principle

Cost Principle The principle that a purchased asset should be recorded at its actual cost Cost Exchange price associated with a business transaction at the point of recognition Exchange price Amount a buyer is willing to pay and a seller is willing to receive Is objective Cost principle is used because cost is verifiable

Applying the Cost Principle Company A purchases building for $80,000 Company A Records purchase of building at original cost (exchange price) of $80,000 Company A offers same building for sale for $120,000 Company A sells building to Company B for $110,000 Company A Records sale of building at sales price (exchange price) of $110,000 and profit or loss is recognized Company B Records purchase of building at cost (exchange price) of $110,000 Company A Company B Only amounts involved in business transactions (exchanges of value) are recorded in the company books

Classification Classification is the process of assigning transactions to the appropriate accounts Proper classification depends on Correctly analyzing the effect of each transaction on the business Maintaining a system of accounts that reflects that effect

Ethics and Measurement Issues Ethical reporting requires that recognition, valuation, and classification are treated properly. Recording a lease agreement at the time leases are signed rather than over the lease term violates guidelines of recognition. Classifying an expenditure as an asset instead of an expense can be a classification violation.

Stop & Apply What three issues underlie most accounting decisions? 1. The recognition issue When a transaction should be recorded 2. The valuation issue What value should be placed on the transaction 3. The classification issue How the components should be categorized

Double-Entry System Objective 2 Explain the double-entry system and the usefulness of T accounts in analyzing business transactions.

What Is the Double-Entry System? Based on principle of duality Every economic event has two aspects that balance, or offset, each other The two aspects represent Effort and reward Sacrifice and benefit Source and use Example: Pay cash to purchase supplies Cash paid = effort, sacrifice, source Supplies received = reward, benefit, use

Principle of Duality Each transaction recorded with at least one debit and one credit Total amount of debits = total amount of credits Whole system always in balance All accounting systems based on principle of duality

Accounts Basic storage units for accounting data Used to accumulate amounts from similar transactions Separate accounts used for: Assets Liabilities Components of stockholders’ equity (includes revenues and expenses)

The T Account Three parts: A title that describes the account A left side, called the debit side A right side, called the credit side Title of Account Debit (left) side Credit (right) side

Analyzing Business Transactions Rules of Double-Entry Bookkeeping Every transaction affects at least two accounts One or more accounts must be debited and one or more accounts must be credited Total debits must equal total credits For each transaction For whole system (all accounts as a group)

Rules of Double-Entry Accounting Stockholders’ Assets = Liabilities + Equity Debit for Increases (+) Credit for Decreases (–) Debit for Decreases (–) Credit for Increases (+) Assets increase with debits Liabilities and Stockholders’ Equity increase with credits Assets decrease with credits Liabilities and Stockholders’ Equity decrease with debits

Components of Stockholders’ Equity Common stock Retained earnings Dividends Revenues Expenses

Effects of Dividends, Revenues, and Expenses on Stockholders’ Equity Common + Retained – Dividends + Revenues – Expenses Stock Earnings Dividends and expenses decrease stockholders’ equity Transactions that increase dividends or expenses decrease stockholders’ equity Revenues increase stockholders’ equity Transactions that increase revenues increase stockholders’ equity

Normal Balance for Asset, Dividend, and Expense accounts: Debit side The usual balance of an account The side (debit or credit) that increases the account Normal Balance for Asset, Dividend, and Expense accounts: Debit side Normal Balance for Liability, Common Stock, Revenue, and Retained Earnings accounts: Credit side

Stockholders’ Equity Accounts Revenue and expense accounts separated from other stockholders’ equity accounts Important for legal and financial reporting purposes Stockholders’ equity accounts represent legal claims by stockholders against assets of company Law requires that capital investments and dividends be separate from revenues and expenses for tax and financial reporting Management needs a detailed breakdown of revenues and expenses for budgeting and operating purposes

Stop & Apply Q. What is an account? A. Basic storage unit for accounting data. Means by which similar transactions are accumulated.

Business Transaction Analysis Objective 3 Demonstrate how the double-entry system is applied to common business transactions.

Analyzing Business Transactions State the transaction. Analyze the transaction to determine which accounts are affected. Apply the rules of double-entry accounting using T accounts. Show the transaction in journal form. Provide a comment that will help apply the rules of debit and credit.

Investment in the Business July 1: Priscilla Treadle invests $40,000 in Treadle Website Design, Inc. in exchange for 40,000 shares $1 par value common stock. Analyze Increase in assets Increase in stockholders’ equity Apply rules Debits increase assets (Cash) Credits increase stockholders’ equity (Common Stock) Record

Prepayment of Expenses in Cash July 3: Rents office and pays two months’ rent in advance, $3,200 Analyze Increase in assets Decrease in assets Apply rules Debits increase assets (Prepaid Rent) Credits decrease assets (Cash) Record

Stop & Review Q. Why does a business record an expense for the telephone bill even though it hasn’t been paid? A. An expense has been incurred for telephone services used. An obligation to pay exists The expense and the liability for telephone service is recorded.

The Trial Balance Objective 4 Prepare a trial balance, and describe its value and limitations.

The Trial Balance For every amount debited, an equal amount must be credited Result: The total of debits and credits for all the T accounts must be equal. Trial balance is prepared to test this Usually prepared at the end of a month or accounting period Can be prepared anytime

Purpose of the Trial Balance The trial balance proves whether the ledger is in balance Total of all debits recorded = Total of all credits recorded What it does not do Prove that all transactions were analyzed correctly Prove that amounts were recorded in the proper accounts Detect whether transactions have been omitted Detect errors of the same amount made in both a debit and a credit

Steps in Preparing a Trial Balance List each account that has a balance Record debit balances in the left column Record credit balances in the right column List accounts in the order that they appear in the financial statements Add each column Compare the column totals Total debits should equal total credits

Trial Balance Record debit balances in left column Record credit balances in right column Total each column

Finding Trial Balance Errors If the debit and credit columns are not equal, look for the following errors A debit was entered in an account as a credit, or visa versa An incorrectly computed account balance Error in carrying the account balance to the trial balance Trial balance summed incorrectly

Finding Trial Balance Errors (cont’d) If trial balance is out of balance by an amount divisible by 2 Caused by recording an account with a debit balance as a credit, or visa versa If trial balance is out of balance by an amount divisible by 9 Caused by transposing two numbers when transferring an amount to the trial balance

Stop & Review Q. Why is the trial balance useful? A. Proves that the debits and credits in the accounts are in balance after all transactions have been posted

Cash Flows and the Timing of Transactions Objective 5 Show how the timing of transactions affects cash flows and liquidity.

Cash Flows Companies must be able to pay bills on time A company bills a client for services rendered = cash receipt is delayed A company performs services for cash = cash receipt is immediate Some transactions generate immediate cash; others do not Cash payments can be delayed by using credit terms offered by vendors

Cash Flows: Treadle Website Design, Inc. Inv. by owner 40,000 3,200 Prepay rent Revenue 2,800 13,320 Purchase equipment Advance revenue 1,400 2,600 Payment on liability Collection of A/R 5,000 4,800 Payment of wages 2,800 Payment of dividends Bal. 22,480 Treadle must ensure that it has adequate cash on hand at all times to pay its debts and maintain ongoing operations.

Stop & Review Q. Why is the timing of cash receipts and payments important? A. Companies must ensure that they have adequate funds on hand at all times to pay debts and continue operations.

Chapter Review Explain how the concepts of recognition, valuation, and classification apply to business transactions and why they are important factors in ethical financial reporting. Explain the double-entry system and the usefulness of T accounts in analyzing business transactions. Demonstrate how the double-entry system is applied to common business transactions.

Chapter Review (cont’d) Prepare a trial balance, and describe its value and limitations. Show how the timing of transactions affects cash flows and liquidity.

Recording and Posting Transactions Supplemental Objective 6 Define the chart of accounts, record transactions in the general journal, and post transactions to the ledger.

The General Journal Why aren’t transactions entered directly into the accounts? Because the debit is recorded in one account and the credit in another, it would be very difficult to Identify individual transactions Find errors Solution Record all transactions chronologically in a journal

Chart of Accounts A list of a firm’s account numbers and account titles The first digit in the account number identifies the major financial statement classification

General Journal General journal is the simplest and most flexible, also called book of original entry A separate journal entry records each transaction Journalizing is the process of recording transactions

Journalizing Transactions Record these items in a journal entry: The date 1 Names of accounts debited and dollar amounts on same line in debit column 2 Names of accounts credited (indented) and dollar amounts on same line in credit column 3 Explanation of transaction 4 Account identification numbers, if appropriate 5

General Ledger Used to record the details of each transaction Used to update each account Ledger accounts are located in the general ledger Advantage of ledger account form over T account is that current balance of account is always available

Ledger Account Form 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 journal page where the original entry for the transaction can be found Dollar amount of entry is entered in appropriate debit or credit column New account balance computed in final two columns after each entry

Posting Transferring journal entry information from the journal to the ledger Posting can be done daily, or less frequently depending on the number of transactions

Posting a Transaction Locate debit account in the ledger Enter date of transaction and journal page number in Post. Ref. column Enter in Debit column amount of debit from journal Calculate account balance and enter in appropriate Balance column In journal Post. Ref. Column, enter account number to which amount was posted Repeat for credit entry

Stop & Review Q. In recording entries in a journal, which is written first, the debit or the credit? How is indentation used in the journal? A. The debit entry is written first. The credit account title is indented once. The explanation is indented twice.