1. Analyzing Business Transactions
Chapter 2
Analyzing Business Transactions

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. 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. Measurement Issues Recognition issue Valuation issue
Classification issue
These issues underlie almost every major decision in financial accounting
Measurement issues are controversial

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. 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
Or, may set up a recognition point
Predetermined time at which a transaction should be recorded

7. Economic Events Events that are not recorded as transactions
Events that are recorded as transactions
Customer buys a service
Customer inquires about a service
Receiving products previously ordered
Ordering products from suppliers
Paying employees for work performed
Hiring new employees

8. Valuation Focuses on assigning a monetary value to a transaction
Most controversial issue in accounting
According to GAAP, use original cost
Also called historical cost
Practice of recording transactions at cost follows the cost principle

9. 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

10. Applying the Cost Principle
Company A purchases building for $80,000
Company A
Records purchase of building at original cost (exchange price) of $80,000
Company A offers same building for sale for $120,000
Company A sells building to Company B for $110,000
Company A
Records sale of building at sales price (exchange price) of $110,000 and profit or loss is recognized
Company B
Records purchase of building at cost (exchange price) of $110,000
Company A
Company B
Only amounts involved in business transactions (exchanges of value) are recorded in the company books

11. Classification
Classification is the process of assigning transactions to the appropriate accounts
Proper classification depends on
Correctly analyzing the effect of each transaction on the business
Maintaining a system of accounts that reflects that effect

12. Ethics and Measurement Issues
Ethical reporting requires that recognition, valuation, and classification are treated properly.
Recording a lease agreement at the time leases are signed rather than over the lease term violates guidelines of recognition.
Classifying an expenditure as an asset instead of an expense can be a classification violation.

13. Stop & Apply What three issues underlie most accounting decisions?
1. The recognition issue
When a transaction should be recorded
2. The valuation issue
What value should be placed on the transaction
3. The classification issue
How the components should be categorized

14. Double-Entry System Objective 2
Explain the double-entry system and the usefulness of T accounts in analyzing business transactions.

15. 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
Example:
Pay cash to purchase supplies
Cash paid = effort, sacrifice, source
Supplies received = reward, benefit, use

16. 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

17. 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)

18. The T Account Three parts: A title that describes the account
A left side, called the debit side
A right side, called the credit side
Title of Account
Debit
(left) side
Credit
(right) side

19. Analyzing Business Transactions
Rules of Double-Entry Bookkeeping
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)

20. Rules of Double-Entry Accounting
Stockholders’
Assets = Liabilities Equity
Debit
for
Increases
(+)
Credit
for
Decreases
(–)
Debit
for
Decreases
(–)
Credit
for
Increases
(+)
Assets increase with debits
Liabilities and Stockholders’ Equity increase with credits
Assets decrease with credits
Liabilities and Stockholders’ Equity decrease with debits

21. Components of Stockholders’ Equity
Common stock
Retained earnings
Dividends
Revenues
Expenses

22. Effects of Dividends, Revenues, and Expenses on 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

23. Normal Balance for Asset, Dividend, and Expense accounts: Debit side
The usual balance of an account
The side (debit or credit) that increases the account
Normal Balance for Asset, Dividend, and Expense accounts: Debit side
Normal Balance for Liability, Common Stock, Revenue, and Retained Earnings accounts: Credit side

24. Stockholders’ Equity Accounts
Revenue and expense accounts separated from other stockholders’ equity accounts
Important for legal and financial reporting purposes
Stockholders’ equity accounts represent legal claims by stockholders against assets of company
Law requires that capital investments and dividends be separate from revenues and expenses for tax and financial reporting
Management needs a detailed breakdown of revenues and expenses for budgeting and operating purposes

25. Stop & Apply Q. What is an account?
A. Basic storage unit for accounting data. Means by which similar transactions are accumulated.

26. Business Transaction Analysis
Objective 3
Demonstrate how the double-entry system is applied to common business transactions.

27. Analyzing Business Transactions
State the transaction.
Analyze the transaction to determine which accounts are affected.
Apply the rules of double-entry accounting using T accounts.
Show the transaction in journal form.
Provide a comment that will help apply the rules of debit and credit.

28. Investment in the Business
July 1: Priscilla Treadle invests $40,000 in Treadle Website Design, Inc. in exchange for 40,000 shares $1 par value common stock.
Analyze
Increase in assets
Increase in stockholders’ equity
Apply
rules
Debits increase assets (Cash)
Credits increase stockholders’ equity (Common Stock)
Record

29. Prepayment of Expenses in Cash
July 3: Rents office and pays two months’ rent in advance, $3,200
Analyze
Increase in assets
Decrease in assets
Apply
rules
Debits increase assets (Prepaid Rent)
Credits decrease assets (Cash)
Record

30. Stop & Review
Q. Why does a business record an expense for the telephone bill even though it hasn’t been paid?
A. An expense has been incurred for telephone services used.
An obligation to pay exists
The expense and the liability for telephone service is recorded.

31. The Trial Balance Objective 4
Prepare a trial balance, and describe its value and limitations.

32. 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

33. Purpose of the Trial Balance
The trial balance proves whether the ledger is in balance
Total of all debits recorded = Total of all credits recorded
What it does not do
Prove that all transactions were analyzed correctly
Prove that amounts were recorded in the proper accounts
Detect whether transactions have been omitted
Detect errors of the same amount made in both a debit and a credit

34. Steps in Preparing a Trial Balance
List each 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 financial statements
Add each column
Compare the column totals
Total debits should equal total credits

35. Trial Balance Record debit balances in left column
Record credit balances in right column
Total each column

36. Finding Trial Balance Errors
If the debit and credit columns are not equal, look for the following errors
A debit was entered in an account as a credit, or visa versa
An incorrectly computed account balance
Error in carrying the account balance to the trial balance
Trial balance summed incorrectly

37. Finding Trial Balance Errors (cont’d)
If trial balance is out of balance by an amount divisible by 2
Caused by recording an account with a debit balance as a credit, or visa versa
If trial balance is out of balance by an amount divisible by 9
Caused by transposing two numbers when transferring an amount to the trial balance

38. Stop & Review Q. Why is the trial balance useful?
A. Proves that the debits and credits in the accounts are in balance after all transactions have been posted

39. Cash Flows and the Timing of Transactions
Objective 5
Show how the timing of transactions affects cash flows and liquidity.

40. Cash Flows Companies must be able to pay bills on time
A company bills a client for services rendered = cash receipt is delayed
A company performs services for cash = cash receipt is immediate
Some transactions generate immediate cash; others do not
Cash payments can be delayed by using credit terms offered by vendors

41. Cash Flows: Treadle Website Design, Inc.
Inv. by owner ,000
3,200 Prepay rent
Revenue ,800
13,320 Purchase equipment
Advance revenue 1,400
2,600 Payment on liability
Collection of A/R 5,000
4,800 Payment of wages
2,800 Payment of dividends
Bal ,480
Treadle must ensure that it has adequate cash on hand at all times to pay its debts and maintain ongoing operations.

42. Stop & Review
Q. Why is the timing of cash receipts and payments important?
A. Companies must ensure that they have adequate funds on hand at all times to pay debts and continue operations.

43. Chapter Review
Explain how the concepts of recognition, valuation, and classification apply to business transactions and why they are important factors in ethical financial reporting.
Explain the double-entry system and the usefulness of T accounts in analyzing business transactions.
Demonstrate how the double-entry system is applied to common business transactions.

44. Chapter Review (cont’d)
Prepare a trial balance, and describe its value and limitations.
Show how the timing of transactions affects cash flows and liquidity.

45. Recording and Posting Transactions
Supplemental Objective 6
Define the chart of accounts, record transactions in the general journal, and post transactions to the ledger.

46. The General Journal
Why aren’t transactions entered directly into the accounts?
Because the debit is recorded in one account and the credit in another, it would be very difficult to
Identify individual transactions
Find errors
Solution
Record all transactions chronologically in a journal

47. Chart of Accounts
A list of a firm’s account numbers and account titles
The first digit in the account number identifies the major financial statement classification

48. General Journal
General journal is the simplest and most flexible, also called book of original entry
A separate journal entry records each transaction
Journalizing is the process of recording transactions

49. Journalizing Transactions
Record these items in a journal entry:
The date 1
Names of accounts debited and dollar amounts on same line in debit column 2
Names of accounts credited (indented) and dollar amounts on same line in credit column 3
Explanation of transaction 4
Account identification numbers, if appropriate 5

50. General Ledger Used to record the details of each transaction
Used to update each account
Ledger accounts are located in the general ledger
Advantage of ledger account form over T account is that current balance of account is always available

51. Ledger Account Form
Account title and number appear at top of account form
The date appears in the first two columns (as in the journal)
Item column is rarely used because explanations already appear in the journal
Post. Ref. column used to note journal page where the original entry for the transaction can be found
Dollar amount of entry is entered in appropriate debit or credit column
New account balance computed in final two columns after each entry

52. Posting
Transferring journal entry information from the journal to the ledger
Posting can be done daily, or less frequently depending on the number of transactions

53. Posting a Transaction Locate debit account in the ledger
Enter date of transaction and journal page number in Post. Ref. column
Enter in Debit column amount of debit from journal
Calculate account balance and enter in appropriate Balance column
In journal Post. Ref. Column, enter account number to which amount was posted
Repeat for credit entry

54. Stop & Review
Q. In recording entries in a journal, which is written first, the debit or the credit? How is indentation used in the journal?
A. The debit entry is written first. The credit account title is indented once. The explanation is indented twice.