© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-1 CHAPTER 2 Processing Accounting Information

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-2 THE ACCOUNT The account is – A detailed record of changes that have occurred in a particular asset, liability, or stockholders’ (owners’) equity item during a period of time –Grouped into three categories, according to the accounting equation: Assets Liabilities Owners’ equity Cash

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-3 THE ACCOUNT Assets are the economic resources that benefit the business now and in the future The Cash account Shows the cash effects of a business’s transactions Includes money and any medium of exchange that a bank accepts at face value

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-4 THE ACCOUNT –The Accounts Receivable account Represents a promise for future receipt –The Inventory (Merchandise, Merchandise Inventory) account Is merchandise held for sale to customers –The Notes Receivable account Is a written pledge that the customer will pay a fixed amount of money by a certain date

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-5 THE ACCOUNT –Prepaid expense accounts Are expenses paid in advance –The Land account Is a record of the cost of land a business owns and uses in its operation –The Buildings account Is the cost of a business’s buildings, e.g., office and manufacturing plant

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-6 THE ACCOUNT –Equipment, Furniture, and Fixtures accounts Record separate asset accounts for each type of equipment

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-7 THE ACCOUNT Liabilities are the debts of the company –The Notes Payable account Includes the amounts that the business must pay on promissory notes –The Accounts Payable account Represents the promise to pay off debts arising from credit purchases –Accrued Liability accounts Are expenses that have not yet been paid, e.g., Interest Payable, Salary Payable, and Income Taxes Payable

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-8 THE ACCOUNT Stockholders’ (Owners’) equity is the owners’ claims to the assets of a corporation –A proprietorship uses a single account –A partnership uses separate accounts for each owner’s capital balance and withdrawals –A corporation uses separate capital accounts for each source of capital

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-9 THE ACCOUNT –The Common Stock account Represents the owners’ investment in the corporation –The Retained Earnings account Shows the cumulative net income earned by the corporation over its lifetime, minus cumulative net losses and dividends –The Dividends account Indicates a decrease in retained earnings when dividends are paid by the corporation

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-10 THE ACCOUNT –Revenues Are reported in a separate account for each increase in stockholders’ equity created by delivering goods or services to customers, e.g., Sales Revenues, Service Revenues, Rent Revenues, Interest Revenues –Expenses Are reported in a separate account for each type of expense, e.g., Cost of Sales, Salary Expense, Rent Expense, Advertising Expense, Utilities Expense

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-11 ACCOUNTING FOR BUSINESS TRANSACTIONS A transaction is any event that both affects the financial position of the business entity and can be reliably recorded

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-12 ACCOUNTING FOR BUSINESS TRANSACTIONS Consider the following transactions for Air & Sea Travel, Inc., and their effect on the accounting equation

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-13 ACCOUNTING FOR BUSINESS TRANSACTIONS The owners invest $50,000 of their money to begin the business, and Air & Sea Travel issues common stock to them TRANSACTION 1

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-14 ACCOUNTING FOR BUSINESS TRANSACTIONS TRANSACTION 2 Air & Sea Travel purchases land for a future office location, paying cash of $40,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-15 ACCOUNTING FOR BUSINESS TRANSACTIONS TRANSACTION 3 The business buys stationery and other office supplies, agreeing to pay $500 to the office-supply store within 30 days

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-16 ACCOUNTING FOR BUSINESS TRANSACTIONS TRANSACTION 4 Air & Sea Travel earns service revenue of $5,500 and collects this amount in cash

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-17 ACCOUNTING FOR BUSINESS TRANSACTIONS Air & Sea Travel performs services for customers on account for $3,000 TRANSACTION 5

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-18 ACCOUNTING FOR BUSINESS TRANSACTIONS Air & Sea Travel pays $2,700 for the following cash expenses: office rent $1,100, employee salary $1,200, and utilities $400 TRANSACTION 6

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-19 ACCOUNTING FOR BUSINESS TRANSACTIONS Air & Sea Travel pays $400 to the store from which it purchased $500 worth of office supplies in Transaction 3 TRANSACTION 7

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-20 ACCOUNTING FOR BUSINESS TRANSACTIONS The owners remodel their home at a cost of $30,000, paying cash from personal funds TRANSACTION 8 This event is a transaction of the personal entity, not the business entity No transaction is recorded for Air & Sea Travel This event is a transaction of the personal entity, not the business entity No transaction is recorded for Air & Sea Travel

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-21 ACCOUNTING FOR BUSINESS TRANSACTIONS The business collects $1,000 from a customer on account TRANSACTION 9

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-22 ACCOUNTING FOR BUSINESS TRANSACTIONS Air & Sea Travel sells land for a price of $22,000, which is equal to the amount it paid for the land TRANSACTION 10

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-23 ACCOUNTING FOR BUSINESS TRANSACTIONS The corporation declares a dividend and pays $2,100 cash to the stockholders TRANSACTION 11

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-24 ACCOUNTING FOR BUSINESS TRANSACTIONS The table on the next slide summarizes the 11 preceding transactions and provides the data that Air & Sea Travel will use to create its financial statements –Data for the statement of cash flows are aligned under the Cash account –Income statement data appear as revenues and expenses under Retained Earnings –The balance sheet data are composed of the ending balances of the assets, liabilities, and stockholders’ equities –The statement of retained earnings, which shows net income (loss) and dividends, can be prepared from the Retained Earnings column

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-25 ANALYSIS OF TRANSACTONS Income Statement Data Statement of Retained Earnings Data

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-26 FINANCIAL STATEMENTS OF AIR & SEA TRAVEL, INC.

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-27 FINANCIAL STATEMENTS OF AIR & SEA TRAVEL, INC.

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-28 FINANCIAL STATEMENTS OF AIR & SEA TRAVEL, INC.

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-29

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-30 DOUBLE-ENTRY ACCOUNTING The Double-Entry System: Each transaction affects at least two accounts

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-31 THE T-ACCOUNT The left side is called the debit side, and the right side is called the credit side Every business transaction involves both a debit and a credit Account Title Debit Credit

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-32 INCREASES AND DECREASES IN THE ACCOUNTS The type of account determines how increases and decreases are recorded in it: CreditDebit Credit + Debit Credit Assets Stockholders’ Equity Liabilities Accounting Equation Rules of Debit and Credit =+

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-33 Assets (debit-balance accounts) are on the opposite side of the equation from liabilities and stockholders’ equity (credit balance accounts) Increases and decreases in assets are recorded in the opposite manner from those in liabilities and stockholders’ equity Liabilities and stockholders’ equity, which are on the same side of the equal sign, are treated in the same way INCREASES AND DECREASES IN THE ACCOUNTS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-34 Reconsider the first transaction in the Air & Sea Travel illustration. Air & Sea Travel received $50,000 cash and issued common stock CashCommon Stock Debit for increase, $50,000 Credit for increase, $50,000 Assets = Liabilities + Stockholders’ Equity INCREASES AND DECREASES IN THE ACCOUNTS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-35 The second transaction is a $40,000 cash purchase of land Assets = Liabilities + Stockholders’ Equity CashCommon Stock Bal. 50,000 Credit for Decrease, 40,000 Land Debit for increase, 40,000 Bal. 50,000 INCREASES AND DECREASES IN THE ACCOUNTS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-36 Assets = Liabilities + Stockholders’ Equity CashCommon Stock Bal. 10,000 Land Bal. 40,000 Bal. 50,000 Credit for Increase, 500 Accounts Payable Office Supplies Debit for increase, 500 Transaction 3 is a $500 purchase of office supplies on account

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-37 ADDITIONAL STOCKHOLDERS’ EQUITY ACCOUNTS: REVENUES AND EXPENSES Revenues are increases in stockholders’ equity that result from delivering goods and services to customers Expenses are decreases in stockholders’ equity due to the cost of operating the business

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-38 Assets Liabilities + Common Stock + Retained Earnings - Dividends + Revenues - Expenses The accounting equation can be expanded to include revenues and expenses + = Stockholders’ Equity

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-39 Debit for increase + Credit for Decrease - Debit for Decrease - Credit for Increase + Debit for Decrease - Credit for Increase + Debit for Increase + Credit for Decrease - Debit for Increase + Credit for Decrease - AssetsLiabilitiesCommon Stock Retained Earnings Dividends Revenues Expenses Debit for Decrease - Credit for Increase + Debit for Decrease - Credit for Increase + =+ Expanded Rules of Debit and Credit

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-40 Accountants record transactions first in a journal: a chronological record of an entity’s transactions RECORDING TRANSACTIONS IN THE JOURNAL

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-41 RECORDING TRANSACTIONS IN THE JOURNAL Steps of the journalizing process –Identify the transaction from source documents, such as bank deposit slips, sale receipts, and check stubs –Specify each account affected by the transaction and classify it by type (asset, liability, stockholders’ equity, revenue, or expense)

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-42 RECORDING TRANSACTIONS IN THE JOURNAL –Determine whether each account is increased or decreased by the transaction –Determine whether to debit or credit the account to record its increase or decrease –Enter the transaction in the journal, including a brief explanation for the entry Enter the debit side first and the credit side next

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-43 RECORDING TRANSACTIONS IN THE JOURNAL A complete journal entry includes ¬The date of the transaction ­The title of the account debited (placed flush left in the Accounts and Explanations column) ®The title of the account credited (indented slightly) ¯The dollar amount of the debit (left) °The dollar amount of the credit (right) ±A short explanation of the transaction (not indented)

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-44 The first transaction of Air & Sea Travel, Inc. DateAccounts and ExplanationDebitCredit Apr. 2  Cash  50,000  Common Stock  50,000  Issued common stock to owners.  DateAccounts and ExplanationDebitCredit Apr. 2  Cash  50,000  Common Stock  50,000  Issued common stock to owners.  RECORDING TRANSACTIONS IN THE JOURNAL

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-45 COPYING INFORMATION (POSTING) FROM THE JOURNAL TO THE LEDGER The ledger is a grouping of all accounts with their balances Data must be copied to the appropriate accounts in the ledger - a process called posting

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-46 Cash Accounts Payable Common Stock Many individual asset accounts Many individual liability accounts Many individual stockholders’ equity accounts All individual accounts combined make up the company’s ledger Ledger

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-47 Cash……………………………..50,000 Common Stock……………. 50,000 Issued common stock to owners Common Stock Cash 50,000 Posting to the Ledger Accounts and Explanation Debit Credit Journal Entry Journal Entry and Posting to the Ledger

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-48 THE FLOW OF ACCOUNTING DATA: PUTTING THEORY INTO PRACTICE Transaction Occurs Source Documents Prepared Transaction Analysis Takes Place Transaction Entered in Journal Amounts Posted to Ledger

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-49 Consider again selected transactions of Air & Sea Travel, Inc. - Transaction 1 Air & Sea Travel, Inc., received $50,000 cash and in turn issued common stock to the owners Transaction analysis Journal entry Cash…………………………..50,000 Common Stock………… 50,000 Issued common stock to owners Accounting equation Assets = Liabilities + Stockholders’ Equity 50,000 = ,000 Ledger Accounts Common Stock (1) 50,000 Cash

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-50 Air & Sea Travel, Inc. - Transaction 2 The business paid $40,000 for land Transaction analysis Journal entry Land…………………………..40,000 Cash……………………. 40,000 Paid cash for land Accounting equation Assets = Liabilities + Stockholders’ Equity +40,000 = ,000 Ledger Accounts Land Cash (1) 50,000 (2) 40,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-51 The business purchased $500 of office supplies on account Transaction analysis Journal entry Office supplies…………………500 Accounts payable……… Purchased office supplies on account Accounting equation Assets = Liabilities + Stockholders’ Equity +500 = Ledger Accounts Accounts Payable Office supplies (3) 500 Air & Sea Travel, Inc. - Transaction 3

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-52 The business performed travel service for clients and received cash of $5,500 Transaction analysis Journal entry Cash…………………………..5,500 Service Revenue……… 5,500 Performed services for cash Accounting equation Assets = Liabilities + Equity + Revenues 5,500 = 0 + 5,500 Ledger Accounts Service Revenue Cash (1) 50,000 (4) 5,500 (2) 40,000 Stockholders’ Air & Sea Travel, Inc. - Transaction 4

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-53 ACCOUNTS AFTER POSTING (1) 50,000 (4) 5,500 (9) 1,000 (10) 22,000 Bal. 33,300 (2) 40,000 (6) 2,700 (7) 400 (11) 2,100 Cash Each account has a balance, denoted as Bal. This amount is the difference between the account’s total debits and total credits

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-54 THE TRIAL BALANCE The trial balance –Is a list of all accounts with their balances Assets first, followed by liabilities and then stockholders’ equity –Aids in the preparation of the financial statements by summarizing all the account balances –Provides a check on accuracy by showing whether total debits equal total credits

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-55

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-56 CORRECTING ACCOUNTING ERRORS If total debits and total credits on the trial balance are not equal, then accounting errors exist

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-57 Reason(s) behind many of the out-of- balance conditions can be detected by computing the difference between debits and credits on the trial balance and performing one or more of the following actions... CORRECTING ACCOUNTING ERRORS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-58 Search the trial balance for a missing account Search the journal for the amount of the difference Divide the difference between total debits and total credits by 2. A debit treated as a credit, or vice versa, doubles the amount of the error Divide the out-of-balance amount by 9. If the result is evenly divisible by 9, the error may be a slide (writing $61 as $610) or a transposition (writing $61 as $16) CORRECTING ACCOUNTING ERRORS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-59 CHART OF ACCOUNTS A chart of accounts lists all accounts and account numbers –Account numbers usually have two or more digits –Assets are often numbered beginning with 1, liabilities with 2, stockholders’ equity with 3, revenues with 4, and expenses with 5 –The second, third, and higher digits in an account number indicate the position of the individual account within the category

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren Cash 201 Accounts Payable 301 Common Stock 111 Accounts Receivable 231 Notes Payable 311 Dividends 141 Office Supplies 312 Retained Earnings 151 Office Furniture 191 Land 401 Service Revenue 501 Rent Expense 502 Salary Expense 503 Utilities Expense ASSETS LIABILITIES STOCKHOLDERS’ EQUITY CHART OF ACCOUNTS BALANCE SHEET ACCOUNTS: INCOME STATEMENT ACCOUNTS (PART OF STOCKHOLDERS’ EQUITY): Revenues Expenses

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-61 THE NORMAL BALANCE OF AN ACCOUNT An account’s normal balance is the side of the account - debit or credit - where increases are recorded –Assets are called debit-balance accounts –Liabilities and stockholders’ equity are called credit-balance accounts

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-62 THE NORMAL BALANCE OF AN ACCOUNT Assets………………………………Debit Liabilities………………………….. Credit Stockholders’ Equity - overall … Credit Common stock ……………... Credit Retained Earnings …………. Credit Dividends………………………Debit Revenues ……………………… Credit Expenses………………………Debit Assets………………………………Debit Liabilities………………………….. Credit Stockholders’ Equity - overall … Credit Common stock ……………... Credit Retained Earnings …………. Credit Dividends………………………Debit Revenues ……………………… Credit Expenses………………………Debit

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-63 FOUR-COLUMN ACCOUNT FORMAT The four-column account format has four amount columns –The first pair of columns are for the debit and credit amounts from journal entries –The second pair of amount columns are for the account’s balance

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-64 Account: Cash Account No. 101 Balance Jrnl. Date Item Ref. Debit Credit Debit Credit 20X1 Apr. 2 J.1 50,000 50,000 3 J.1 40,000 10,000 Account: Cash Account No. 101 Balance Jrnl. Date Item Ref. Debit Credit Debit Credit 20X1 Apr. 2 J.1 50,000 50,000 3 J.1 40,000 10,000 FOUR-COLUMN ACCOUNT FORMAT

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 2-65 End of Chapter 2