Chapter 2 Recording Business Transactions

Learning Objectives Explain accounts as they relate to the accounting equation and describe common accounts Define debits, credits, and normal account balances using double-entry accounting and T-accounts Record transactions in a journal and post journal entries to the ledger

Learning Objectives Prepare the trial balance and illustrate how to use the trial balance to prepare financial statements Use the debt ratio to evaluate business performance

Learning Objective 1 Explain accounts as they relate to the accounting equation and describe common accounts

What Is an Account? The accounting equation contains three parts: assets, liabilities, and equity. Each part contains accounts. An account is the detailed record of all increases and decreases that have occurred in an account during a specified period. The accounting equation is the basic tool of accounting. The accounting equation is made up of three categories: assets, liabilities, and equity. Each category contains accounts, which is a detailed record of all increases and decreases that have occurred in an individual account during a specific period.

Assets Assets are something the business owns or has control of that has value. Assets are economic resources that are expected to benefit the business in the future. Many examples were introduced in Chapter 1, such as cash, accounts receivable, equipment, building, and land. Accounts Receivable represent a customer’s promise to pay monies in the future for services or goods already provided. Equipment, furniture, fixtures, and land are assets used by businesses in operations. Two new assets introduced are Notes Receivable and Prepaid Expenses. Notes Receivable represents a promise by a customer to pay a fixed amount of money along with interest on a specific date. Generally, Notes Receivable require a formal promissory note which includes a stated interest rate. Prepaid Expenses are expenses paid in advance that are expected to benefit the business in the future. Examples of Prepaid Expenses include Prepaid Rent, Prepaid Insurance, and Office Supplies.

Liabilities A liability is a debt, something that the business owes. A business generally has fewer liabilities than asset accounts. A payable involves a future payment of cash. A note payable is a written promise made by the business to pay a liability in the future and generally includes interest. An accrued liability is an amount owed for goods or services provided but not yet paid by the business. Unearned revenue occurs when a company receives cash from a customer before the business provides the goods or services.

Equity The stockholders’ claim to the assets of the business is called equity, or stockholders’ equity. A company has separate accounts for each element of equity. Equity is increased for Common Stock and Revenues and decreased for Dividends and Expenses.

Chart of Accounts A chart of accounts is used to organize a company’s accounts. A ledger is a record holding all the accounts of a business, the changes in those accounts, and their balances. Exhibit 2-4 shows the chart of accounts for Smart Touch Learning. A chart of accounts is used to organize a company’s accounts. A chart of accounts lists all company accounts along with the account numbers. Account numbers are just shorthand versions of the account names. Each account has an individual account number, similar to how Social Security numbers are unique to each of us. The chart of accounts varies from business to business, though most account names are common to all companies. In addition to a chart of accounts, companies need a way to show all of the increases and decreases in each account along with their balances. A ledger is used to complete this task. A ledger is a collection of all the accounts, the changes in those accounts, and their balances. A ledger provides more detail than a chart of accounts.

Learning Objective 2 Define debits, credits, and normal account balances using double-entry accounting and T-accounts

What Is Double-Entry Accounting? Transactions always involve at least two accounts. Accounting uses the double-entry system to record the dual effects of each transaction. For example, office supplies are purchased for cash requiring an increase in Office Supplies and a decrease in Cash. In accounting, the double-entry system is used to record the dual effects of every transaction. A transaction would be incomplete if only one side of the transaction were recorded. In addition, recording only one side of the transaction leaves the accounting equation out of balance.

The T-Account A shortened form of the ledger is called the T-account. The left side of the T-account is called the debit. The right side of the T-account is called a credit. A T-account is a shortened form of the ledger and is called a T-account because it resembles a capital T. The name of the account is listed on top of the T. The left and right sides of the T-account are used to record increases and decreases in the account. Debit is abbreviated as DR, and credit is abbreviated as CR.

Increases and Decreases in the Accounts How we record increases and decreases to an account is determined by the account type. Increases and decreases to an account are determined by the type of account: asset, liability, or equity. Depending on the type of account, increases are recorded on one side, and decreases are recorded on the opposite side. Assets are always increased with a debit and decreased with a credit. Liabilities and equity are always increased with a credit and decreased with a debit. Debits are not always increases or always decreases, and neither are credits. The debit or credit designates on which side of the T-account the transaction is recorded.

Increases and Decreases in the Accounts To increase the Cash account, a business would record a debit to Cash. To decrease the Cash account, a business would record a credit to Cash. Assume a company enters into a transaction that increases cash, and the Cash account is debited for $30,000. On the other hand, a decrease to Cash is done with a credit.

Expanding the Rules of Debit and Credit The accounting equation is expanded to include the rules of debits and credits for the elements of equity: The accounting equation is expanded to include the four types of equity accounts: Common Stock, Dividends, Revenues, and Expenses. Common Stock and Revenue both increase Equity, but Dividends and Expense accounts increase with a debit, which results in a decrease in equity.

The Normal Balance of an Account All accounts are summarized on one side of the T-account, called the normal balance. An account’s normal balance appears on the increase side of the account. Assets increase with a debit, so the normal balance is a debit. Liabilities and equity increase with a credit, so the normal balance is a credit. All accounts have a normal balance. An account’s normal balance is on the side of the account that increases the account. Assets, Dividends, and Expenses are increased with a debit; therefore, the normal balance for these accounts is a debit. Revenues, Liabilities, and Equity increase with a credit; therefore, the normal balance for these accounts is a credit.

The Normal Balance of an Account Exhibit 2-5 summarizes the normal balances for each type of account. As the table shows, Assets, Expenses, and Dividends all increase with debits and have a normal debit balance. Liabilities, Revenues, and Common Stock increase with a credit and therefore have a normal credit balance.

Determining the Balance of a T-Account Use the T-account to determine the ending balance in an account. The ending balance is shown on the side with the larger number. The T-account is used to obtain a summary, or balance, of a particular account. The summation of the account is reported on the side of the T-account with the larger number. For example, if the total debits for Cash equal $35,500 and the credits are $23,200 the normal balance is $12,300. The total of the debits is subtracted from the credits to determine the ending balance.

Learning Objective 3 Record transactions in a journal and post journal entries to the ledger

How Do You Record Transactions? Accountants use source documents to provide evidence and data for recording transactions. The documents help businesses determine how to record the transactions. Source documents provide the information needed by accounts to record accounting transactions. Based on these documents, the business can determine how to record transactions.

Source Documents—The Origin of the Transactions The next major step in the recording process is to formally enter the transaction information into the general journal. Essentially, the general journal is a chronological record of each of the transactions, recorded in a standardized format. Other source documents used include: Purchase invoices Bank checks Sales invoices

Journaling and Posting Transactions After reviewing source documents, accountants record the transactions. Transactions are recorded in a journal. A journal is the record of the transactions in date order Transferring data from the journal to the ledger is called posting. Accountants use the source documents to record transactions in the journal. A journal is a record of the transactions in date order. The journal is not a record holding all of the accounts, so data must be transferred from the journal to the ledger through the posting process.

Transaction 1—Stockholder Contribution On November 1, the e-learning company received $30,000 cash from Sheena Bright, and the business issued common stock to her. In Transaction 1, Smart Touch Learning received cash from Sheena Bright in exchange for common stock of $30,000. Cash is increased with a debit, and Common Stock is increased with a credit. The accounting equation is in balance, as both sides of the accounting equation were increased by $30,000.

Transaction 1—Stockholder Contribution Once the accounts affected by the transaction are identified, the transaction is recorded in the journal with a journal entry. The journal entry contains four parts: the date of the transaction, the debit account name and dollar amount, the credit account name and dollar amount, and an explanation.

Transaction 1—Stockholder Contribution After the journal entry is recorded, the transaction can be posted to the ledger. The dollar amounts are transferred from the journal to the ledger with a debit or credit identical to the debit and credit used in the journal. This step is automated when computerized systems are used to record the business transactions.

Transaction 2—Purchase of Land for Cash On November 2, Smart Touch Learning paid $20,000 cash for land. In this transaction, the two accounts involved are Land and Cash. Cash is decreased because Smart Touch Learning paid cash for the asset. Land is increased, so we debit the Land account. The accounting equation is still in balance because Land was increased with a debit and Cash was deceased with a credit of the same amount.

Transaction 3—Purchase of Office Supplies on Account Smart Touch Learning buys $500 of office supplies on account on November 3. The two accounts involved are Office Supplies and Accounts Payable. The supplies will benefit Smart Touch Learning in the future, so Office Supplies is an asset and increased with a debit. The liability Accounts Payable is increased with a credit because Smart Touch Learning purchased the supplies on account.

Transaction 4—Earning of Service Revenue for Cash On November 8, Smart Touch Learning collected cash of $5,500 for service revenue that the business earned by providing services for clients. The two accounts involved are Cash and Service Revenue. Cash is increased with a debit because customers paid Smart Touch Learning with cash. Since services were performed, Service Revenue is increased with a credit.

Transaction 5—Earning of Service Revenue on Account On November 10, Smart Touch Learning performed services for clients, for which the clients will pay the company later. The two accounts involved are Accounts Receivable and Service Revenue. Smart Touch Learning provided services for a customer who has promised to pay for the services in the future. Service Revenue is increased with a credit. Accounts Receivable is increased with a debit.

Transaction 6—Payment of Expenses with Cash Smart Touch Learning paid cash expenses on November 15: $2,000 for office rent and $1,200 for employee salaries. The three accounts involved are Rent Expense, Salaries Expense, and Cash. Rent Expense and Salaries Expense are both increased with a debit. Cash is decreased with a credit since cash was used to pay for these expenses. An entry with more than two accounts is called a compound journal entry. This entry is a compound journal entry because it has two debits and one credit. Notice the total amounts for debits equal $3,200, which is the same as the credit of $3,200. Note: A journal entry with more than two accounts is called a compound journal entry.

Transaction 7—Payment on Account (Accounts Payable) On November 12, Smart Touch Learning paid $300 on the accounts payable created in Transaction 3. The two accounts involved are Accounts Payable and Cash. Accounts Payable is decreased with a debit because Smart Touch Learning is paying the amount due to the vendor, thereby decreasing the balance owed. Cash is decreased with a credit.

Transaction 8—Collection on Account (Accounts Receivable) On November 22, Smart Touch Learning collected $2,000 cash from a client in Transaction 5. The two accounts involved are Cash and Accounts Receivable. Cash is collected from a customer and is increased with a debit. Accounts Receivable is decreased with a credit, and we note that the customer no longer owes Smart Touch Learning the $2,000 balance.

Transaction 9—Payment of Cash Dividend On November 25, a payment of $5,000 cash was paid for dividends. The two accounts involved are Dividends and Cash. Dividends are increased with a debit and decrease equity. Cash is decreased to pay the dividend to the stockholder.

Transaction 10—Prepaid Expenses On December 1, Smart Touch Learning prepays three months’ office rent of $3,000. The two accounts involved are Prepaid Rent and Cash. Prepaid rent is increased with a debit because it is an asset. Cash is decreased with a credit.

Transaction 11—Payment of Expense with Cash On December 1, Smart Touch Learning paid employee salaries of $1,200. The two accounts involved are Salaries Expense and Cash. Smart Touch Learning paid employees for salaries, so Cash is decreased with a credit. Salaries Expense is increased with a debit, which decreased equity.

Transaction 12—Purchase of Building with Notes Payable On December 1, Smart Touch Learning purchased a $60,000 building in exchange for a note payable. The two accounts involved are Building and Notes Payable. Smart Touch Learning purchased a building, an asset, so we debit the Building asset account. The business borrowed to purchase the building, so Notes Payable is increased with a credit.

Transaction 13—Stockholder Contribution On December 2, Smart Touch Learning received a contribution of furniture with a fair market value of $18,000 from Sheena Bright. The two accounts involved are Furniture and Common Stock. Sheena Bright contributed furniture to Smart Touch Learning, so the asset account Furniture is increased with a debit. In return, Sheena receives common stock, so the Common Stock account is increased with a credit and increases equity.

Transaction 14—Accrued Liability On December 15, Smart Touch Learning received a telephone bill for $100 and will pay this expense next month. The two accounts involved are Utilities Expense and Utilities Payable. Utilities Expense is increased, so we debit the expense account. A liability exists because Smart Touch Learning still owes the utility company, so the Utilities Payable account is increased with a credit.

Transaction 15—Payment of Expense with Cash On December 15, Smart Touch Learning paid employee salaries of $1,200. The two accounts involved are Salaries Expense and Cash. Smart Touch Learning pays employees with cash, so the Cash account is decreased with a credit. Salaries Expense is increased with a debit, and equity is decreased .

Transaction 16—Unearned Revenue On December 21, a law firm engaged Smart Touch Learning to provide e-learning services and agreed to pay $600 in advance. The two accounts involved are Cash and Unearned Revenue. Cash is received from customers in advance, so Cash is increased with a debit. Unearned Revenue is a liability and is increased with a credit.

Transaction 17—Earning of Service Revenue for Cash On December 28, Smart Touch Learning collected cash of $8,000 for Service Revenue that the business earned by providing e-learning services for clients. The two accounts involved are Cash and Service Revenue. Customers paid for services immediately after they were performed, so Cash is increased with a debit. Service Revenue is increased with a credit and is an increase in in equity.

The Ledger Accounts After Posting Exhibit 2-7 shows Smart Touch Learning’s accounts after posting journal entries in November and December. Notice the total assets of $114,700 equals the total liabilities of $60,900 plus equity of $53,800. Total liabilities plus equity is: $60,900+$53,800=$114,700. After recording the journal entries, the amounts are posted to the ledger. Exhibit 2-7 is a summary of the ledger accounts. The accounting equation is in balance as assets equal $114,700, and liabilities plus equity also equals $114,700.

The ledger reports the ending balances in the asset accounts after the journal entries are posted, shown in Exhibit 2-7. The assets portion of Exhibit 2-7.

The Ledger Accounts After Posting The liabilities and equity portions of Exhibit 2-7. Notice the liabilities and equity values of $60,900 and $53,800 equal total assets of $114,700.

The Four-Column Account: An Alternative to the T-Account The four-column account is an alternative to the T-account. The four-column account has debit and credit columns as well as a running balance of the account. Similar to the T-account, the four-column account lists the date of the journal entry, a posting reference, and the debit or credit amount.

Exhibit 2-9 shows the posting and associated posting references for Transaction 1 of Smart Touch Learning. This process is automated in a computerized environment.

Learning Objective 4 Prepare the trial balance and illustrate how to use the trial balance to prepare financial statements

What Is the Trial Balance? A trial balance is a summary of the ledger listing all of the accounts with their balances. The asset accounts are listed first, followed by liabilities, and then equity. A trial balance is prepared after the journal entries have been posted to the ledger. The trial balance is a summary of all the accounts with their balances. The trial balance lists the assets, liabilities, and equity, in that order. The purpose of the trial balance is to check whether or not the debits equal the credits.

Preparing Financial Statements from the Trial Balance In addition to verifying the equality of debits and credits, the trial balance is used to prepare the financial statements. The account balances are taken directly from the trial balance to prepare the income statement, statement of retained earnings, and balance sheet.

Correcting Trial Balance Errors Search for missing accounts. Divide the difference between total debits and total credits by 2. A debit treated as a credit or vice versa doubles the error. Divide the out-of-balance amount by 9 to find transposition errors. If the debits and credits are not equal, an error exists. Balance errors can be located by performing a search on the trial balance for any missing accounts. Dividing the difference between total debits and credits by 2 locates doubling errors, which occur when a debit is treated as a credit or vice versa. Transposition errors (e.g., when an amount was recorded as $2,100 instead of $1,200) may exist when there is an out-of-balance error. If the result is evenly divisibly by 9, the error may be a transposition or slide, such as recording $1,000 instead of $100.

Learning Objective 5 Use the debt ratio to evaluate business performance

How Do You Use the Debt Ratio to Evaluate Business Performance? The debt ratio shows the proportion of assets financed with debt. It can be used to evaluate a business’s ability to pay its debts and to determine if the company has too much debt to be considered financially “healthy.” The debt ratio is used to evaluate a business’s ability to pay its debts. The debt ratio shows the proportion of assets financed with debt. Companies with a high percentage of liabilities are at greater risk of default, meaning they would be unable to pay their creditors.