CHAPTER 4 THE BOOKKEEPING PROCESS AND TRANSACTION ANALYSIS McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 1.How can the basic accounting equation be expanded to include revenues and expenses? 2.How does the expanded accounting equation stay in balance after every transaction? 3.How is the income statement linked to the balance sheet through owners’ equity? 4.What are the meanings of the terms journal, ledger, T-account, account balance, debit, credit, and closing the books? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 5.How is the bookkeeping system a mechanical adaptation of the expanded accounting equation? 6.How is a transaction analyzed, how is a journal entry prepared, and how is the effect of a transaction on working capital determined? 7.What are the five questions of transaction analysis? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 1 How can the basic accounting equation be expanded to include revenues and expenses? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Bookkeeping/Accounting Process The process begins with transactions The transactions are reflected in the financial statements One must know the mechanical process to understand the effects of transactions on the financial statements McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

The Balance Sheet Equations The basic equation is: Assets = Liabilities + Owners’ Equity Since Owners’ Equity consists of Paid- In Capital and Retained Earnings, the equation can be restated as: Assets = Liabilities + (Paid-In Capital + Retained Earnings) McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

The Balance Sheet Equations Since Retained Earnings is computed as Beginning Retained Earnings plus Revenues and less Expenses, the basic equation can be restated as: Assets = Liabilities + (Paid-In Capital + Beginning Retained Earnings + Revenues – Expenses) McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 2 How does the expanded accounting equation stay in balance after every transaction? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

EXHIBIT 4-1 Transaction Summary McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 3 How is the income statement linked to the balance sheet through owners’ equity? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Linking the Income Statement and the Balance Sheet The Net Income on the Income Statement gets into the Balance Sheet through the Retained Earnings section of Owners’ Equity See the previous slide for an example McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 4 What are the meanings of the terms journal, ledger, T-account, account balance, debit, credit, and closing the books? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Bookkeeping Jargon and Procedures Journal – where transactions are initially recorded Post – to record Ledger – a set of accounts for each category of asset, liability, and owners’ equity Chart of accounts – an index to the ledger T-Account – an account format that looks like a “T.” One side indicates an addition; the other a subtraction from the account Debit – the left side Credit – the right side McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 5 How is the bookkeeping system a mechanical adaptation of the expanded accounting equation? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

The Bookkeeping System Debits must always equal credits Asset accounts will normally have debit balances Increases in assets are entered as debits; decreases are entered as credits Liabilities and Owners’ Equity are the opposite of Assets. Debits are decreases and credits are increases McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Journal Entries The journal is the book of original entry The format for a journal entry is as follows: Date Dr. Account name Amount Cr.Account name Amount Note the date is entered for reference Dr. and Cr. are used for debit and credit A journal entry may have more than one debit and more than one credit McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 6 How is a transaction analyzed, how is a journal entry prepared, and how is the effect of a transaction on the financial statements determined? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Transaction Effects - Balance Sheet The horizontal model is an alternative to using T- accounts and journal entries The model is as follows: Balance Sheet Income Statement Assets = Liabilities + Owners’ Equity Net Income = Revenues – Expenses (Accounts and amounts affected by transactions are entered under the appropriate categories) McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Adjusting Entries Made to reflect accrual accounting in the financial statements Results in revenues and expenses being reported in the appropriate fiscal period Two types of adjusting entries Accruals Reclassifications McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Accruals and Reclassifications Accruals- transactions for which cash has not yet been received or paid, but revenues and expenses need to be matched Reclassifications – the initial recording of a transaction must be reclassified to reflect when revenues were earned or when expenses were incurred McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Accruals Example: Work performed by employees in March, but paid in April At the end of March debit Wages Expense and credit Wages Payable Example: Interest earned in March, but not received At the end of March debit Interest Receivable and credit Interest Revenue McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Reclassifications Example: Supplies are purchased in February and are recorded as an asset. Then the supplies are used. The expense Supplies Expense should be debited and the asset Supplies should be credited for the amount of supplies used If the purchased supplies were debited to Supplies Expense when purchased, the unused supplies should be debited to the asset account and the Supplies Expense account should be credited McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Adjusting Entries Revisited Generally, every adjusting entry affects both the Balance Sheet and the Income Statement After the adjusting entries have been made, the account balances are determined, and the financial statements are prepared McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 7 What are the five questions of transaction analysis? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Five Transaction Analysis Questions What’s going on? What accounts are affected? How are they affected? Does the Balance Sheet balance? (Do the debits equal the credits?) Does my analysis make sense? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

What’s Going On? To analyze a transaction, the transaction must be understood It is necessary to understand the entity for which accounting is being done and standard business practices McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

What Accounts Are Affected? Often the accounts affected are explained by understanding what is going on Can also be answered by the process of elimination McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

How Are They Affected? Answer this by using “increasing” or “decreasing” Then relate the increases and decreases to debits and credits to the appropriate accounts If using the horizontal model, debits and credits are avoided McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Does the Balance Sheet Balance? If using the horizontal model, the answer is found easily Remember that debits must equal credits and assets must equal liabilities plus owners’ equity McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Does My Analysis Make Sense? Think about the effect of the transaction on the financial statements Do the effects that you have recorded reflect what happened? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002