Chapter 3: Processing Accounting Information

Assets = Liabilities + Equity Transaction Analysis The first step in the accounting process is transaction analysis. This process examines relevant, objectively measurable economic events through their effect on the accounting equation: Assets = Liabilities + Equity

Transaction Analysis All business transactions will have an effect on at least 2 items in the accounting equation. For example, if you buy a car with cash, you decrease one asset (cash) and increase another asset (auto). If you purchased a car by signing a note, you would increase an asset (auto), and increase a liability (notes payable).

Class Problem Using a spreadsheet approach, analyze the transactions listed on the next slide. Note that effects may be on both sides of the equation (in the same direction), or effects may be on one side of the equation with offsetting directions. Each transaction will affect at least 2 items in the accounting equation. The equation will still be in balance after the transaction is posted.

Class Problem - Transactions The following activities were during the first month of operation of Cordova Repair Company: The owners of Cordova Repair Company contributed $20,000 cash in exchange for stock ownership in the company. Cordova purchased equipment which cost $20,000. Cordova paid $8,000 cash and financed the balance at the bank. Cordova completed repair services on a fleet of automobiles for Collierville Corporation, and billed Collierville $8,000 for the services. Cordova paid rent expense of $5,000 for the month. Cordova collected $4,000 from Collierville Co. Cordova distributed a $500 dividend to its shareholders.

Class Problem -Spreadsheet Cash + A/R + Equip. = N/P + CS + RE 1. = 2. = 3. = 4. = 5. = 6. _____ _____ _____= _____ _____ _____

Class Problem: Financial Statements Income Statement Revenues $8,000 Expenses 5,000 Net Income $3,000 Statement of Retained Earnings RE (beginning) $ 0 Add: Net Income 3,000 Less: Dividends (500) RE (ending) $2,500

Class Problem: Financial Statements Balance Sheet Assets Cash $10,500 A/R 4,000 Equipment $20,000 Total $34,500 Liabilities and S.E. N/P $ 12,000 CS 20,000 RE (ending) 2,500 Total $34,500

The Accounting Process The first step in the accounting process is transaction analysis. The second step is the recording of transactions and events (journal entries). The third step is the posting of the information to the ledger accounts (general ledger). The fourth step is the preparation of the trial balance (this is used to construct the financial statements).

The Double Entry System Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is not sufficient. Therefore accountants use a “double entry” system based on debits and credits.

Double Entry Accounting Debit (dr) - means an entry to the left hand side of an account. Credit (cr) - means an entry to the right hand side of an account. Note that a debit or credit, per se, does not indicate increase or decrease. To decide the effect of a debit or credit, the type of account must be considered.

Effect of Debits and Credits Based on the accounting equation, we can increase or decrease various accounts depending on their classification: Assets = Liabilities + Equity Increase DR = CR CR Decrease CR = DR DR Note that we use debits and credits instead of plusses and minuses. Note, also, that bank terminology is reversed from the customer perspective.

The following rules can be derived from the basic formula: Assets have normal debit balances and are increased with a debit. Liabilities and equities have normal credit balances and are increased with a credit. Revenues (a part of equity) have normal credit balances and are increased with a credit. Expenses (which decrease equity) have normal debit balances and are increased with a debit. Dividends (which decrease equity) have a normal debit balance and are increased with a debit.

The Format of a Journal Entry To initially record transactions, we use a journal entry to represent the debits and credits. For example, in the Chapter 3 Class Problem, Item 1: Debit Credit Cash 20,000 Common Stock 20,000 Note that the debit is to the left and the credit is to the right. First we list the account (left hand entry on top), then the amount.

Now back to the Class Problem and prepare the other journal entries: 2: Purchased equip. costing $20,000. 3: Billed customer $8,000.

Now back to the Class Problem, and prepare the other journal entries: 4: Paid $5,000 cash for expenses. 5: Collected $4,000 from customer.

Now back to the Class Problem, and prepare the other journal entries: 6: Paid $500 cash dividend to owners. Note that dividends is a contra equity and reduces retained earnings.

The Accounting Cycle Components of the basic accounting cycle include: A. Preparation of Journal Entries (Chapter 3) -Post to the General Ledger -Unadjusted Trial Balance B. Preparation of Adjusting Journal Entries (Chapter 4) -Adjusted Trial Balance C. Financial Statements (Chapter 4) D. Closing Journal Entries (Chapter 4) -Post ClosingTrial Balance

A. General Journal Entries (GJEs) The first step in the accounting process. Prepared for daily activity. Usually journalized in special journals for efficiency, but we will record in “General Journal” format. Identified through a document flow: cash receipt, record a cash sale charge receipt, record a sale on account bank note, record a notes payable employee time card, record wages The Journal Entries from the Class Problem are GJEs.

The General Ledger (G/L) The G/L serves as a place to “total” amounts by account titles. After GJEs (and later – adjusting journal entries) are recorded, they are posted (by account) to the G/L. We will use “T” accounts to represent G/L accounts where needed.

Back to Class Problem: Posting to G/L Now post transactions (for Cash) to “T” account:

Unadjusted Trial Balance Trial balances are prepared throughout the accounting cycle. The Unadjusted Trial Balance represents G/L totals (by account) at a particular point in time. From the Chapter 3 Class Problem, the Unadjusted Trial Balance would consist of a list of all of the ending debit or credit balances taken from the various “T” account totals (illustrated on the next slide). The Unadjusted Trial Balance is a preliminary total, and is a starting point for the Adjusting Journal Entries (discussed in next chapter).

Unadjusted Trial Balance – Class Problem (after posting and totaling G/L accounts) Debit Credit Cash 10,500 Accounts Receivable 4,000 Equipment 20,000 Notes Payable 12,000 Common Stock 20,000 Retained Earnings-Begin 0 Revenues 8,000 Expenses 5,000 Dividends 500 Totals 40,000 40,000

Unadjusted Trial Balance The Unadjusted Trial Balance is the starting point for the financials, but other analyses must be performed and recorded before the financial statements are complete. These analyses are discussed in Chapter 4.