1. Copyright © Cengage Learning. All rights reserved. Chapter 2 Analyzing Business Transactions

2. Copyright © Cengage Learning. All rights reserved. 2-2 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.

3. Copyright © Cengage Learning. All rights reserved. 2-3 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

4. Copyright © Cengage Learning. All rights reserved. 2-4 Measurement Issues Recognition issue Valuation issue Classification issue These issues underlie almost every major decision in financial accounting.

5. Copyright © Cengage Learning. All rights reserved. 2-5 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.

6. Copyright © Cengage Learning. All rights reserved. 2-6 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

7. Copyright © Cengage Learning. All rights reserved. 2-7 Valuation Focuses on assigning a monetary value to a transaction. Practice of recording transactions at cost follows the cost principle.

8. Copyright © Cengage Learning. All rights reserved. 2-8 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.

9. Copyright © Cengage Learning. All rights reserved. 2-9 Classification Classification is the process of assigning transactions to the appropriate accounts

10. Copyright © Cengage Learning. All rights reserved. 2-10 Double-Entry System Objective 2 –Explain the double-entry system and the usefulness of T accounts in analyzing business transactions.

11. Copyright © Cengage Learning. All rights reserved. 2-11 Example: Pay cash to purchase supplies Cash paid = effort, sacrifice, source Supplies received = reward, benefit, use 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

12. Copyright © Cengage Learning. All rights reserved. 2-12 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.

13. Copyright © Cengage Learning. All rights reserved. 2-13 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).

14. Copyright © Cengage Learning. All rights reserved. 2-14 Three parts: Title of Account 2. A left side, called the debit side Debit (left) side 3. A right side, called the credit side Credit (right) side 1. A title that describes the account The T Account

15. Copyright © Cengage Learning. All rights reserved. 2-15 Analyzing Business Transactions Rules of Double-Entry Accounting –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)

16. Copyright © Cengage Learning. All rights reserved. 2-16 Accounts and the Accounting Equation Stockholders’ Assets = Liabilities + Equity Debit for Increases (+) Credit for Increases (+) Credit for Increases (+) * Assets increase with debits. * Liabilities and Stockholders’ Equity increase with credits. * Assets decrease with credits. Credit for Decreases (–) * Liabilities and Stockholders’ Equity decrease with debits. Debit for Decreases (–) Debit for Decreases (–)

17. Copyright © Cengage Learning. All rights reserved. 2-17 Normal Balance for Asset, Dividend, and Expense accounts: Debit side Normal Balance for Liability, Common Stock, Revenue, and Retained Earnings accounts: Credit side Normal Balance The usual balance of an account The side (debit or credit) that increases the account

18. Copyright © Cengage Learning. All rights reserved. 2-18 Components of Stockholders’ Equity Common stock Retained earnings Dividends Revenues Expenses

19. Copyright © Cengage Learning. All rights reserved. 2-19 Effects of Dividends, Revenues, and Expenses on Stockholders’ Equity 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

20. Copyright © Cengage Learning. All rights reserved. 2-20 Business Transaction Analysis Objective 3 –Demonstrate how the double-entry system is applied to common business transactions.

21. Copyright © Cengage Learning. All rights reserved. 2-21 Investment in Company Analyze Apply rules Record July 1: Joan Miller invests $40,000 in Miller Design Studio, Inc. in exchange for 40,000 shares $1 par value stock. Increase in assets Increase in stockholders’ equity Debits increase assets (Cash) Credits increase stockholders’ equity (Common Stock)

22. Copyright © Cengage Learning. All rights reserved. 2-22 Purchase Assets Analyze Apply rules Record July 3: Rents office and pays two months’ rent in advance, $3,200 Increase in assets Decrease in assets Debits increase assets (Prepaid Rent) Credits decrease assets (Cash)

23. Copyright © Cengage Learning. All rights reserved. 2-23 The Trial Balance Objective 4 –Prepare a trial balance, and describe its value and limitations.

24. Copyright © Cengage Learning. All rights reserved. 2-24 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

25. Copyright © Cengage Learning. All rights reserved. 2-25 Steps in Preparing a Trial Balance 1.List each T 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 ledger 2.Add each column 3.Compare the column totals –Total debits should equal total credits

26. Copyright © Cengage Learning. All rights reserved. 2-26 Trial Balance Record debit balances in left column Record credit balances in right column Total each column

27. Copyright © Cengage Learning. All rights reserved. Chapter Review 1.Explain how the concepts of recognition, valuation, and classification apply to business transactions and why they are important factors in ethical financial reporting. 2.Explain the double-entry system and the usefulness of T accounts in analyzing business transactions. 3.Demonstrate how the double-entry system is applied to common business transactions. 4.Prepare a trial balance, and describe its value and limitations. 2-27