Analyzing Transactions

Analyzing Transactions
Chapter 2 Analyzing Transactions Accounting, 21st Edition Warren Reeve Fess © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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After studying this chapter, you should be able to:
Objectives 1. Explain why accounts are used to record and summarize the effects of transactions on financial statements. 2. Describe the characteristics of an account. 3. List the rules of debit and credit and the normal balances of accounts. 4. Analyze and summarize the financial statement effects of transactions. After studying this chapter, you should be able to:

Objectives 5. Prepare a trial balance and explain how it can be used to discover errors. 6. Discover errors in recording transactions and correct them. 7. Use horizontal analysis to compare financial statements from different periods.

Each financial statement item, called an account, is included in the ledger.

A group of accounts for a business entity is called a ledger.

A list of the accounts in a ledger is called a chart of accounts.

Major Account Classifications
Assets are resources owned by the business. Liabilities are debts owed to outsiders (creditors). Cash Supplies Building Accounts receivable Accounts payable Notes payable Wages payable

Liabilities are often identified on the balance sheet by titles that include payable. Assets are resources owned by the business. Liabilities are debts owed to outsiders (creditors). Cash Supplies Building Accounts receivable Accounts payable Notes payable Wages payable

Owner’s equity is the owner’s right to the assets of the business. Revenues are increases in owner’s equity as a result of selling services or products. Expenses are the using up of assets or consuming of services to generate revenue. Chris Clark, Capital Chris Clark, Drawing Rent Expense Salary Expense Utilities Expense Fees Earned Fares Earned Commission Revenue

To assist you in learning, an account can be drawn to resemble the letter T.

The T-account has a title.
Cash The T-account has a title.

The left side of the account is the debit side.
The T-Account Cash Left side debit The left side of the account is the debit side.

The right side of the account is the credit side.
The T-Account Cash Left side debit Right side credit The right side of the account is the credit side.

The T-Account Cash 3,750 4,300 2,900 850 1,400 700 2,900 Typical entries

Balancing a T-Account

First, foot the debit side.
Cash First, foot the debit side. 3,750 4,300 2,900 850 1,400 700 2,900 10,950

Cash 3,750 4,300 2,900 850 1,400 700 2,900 Next, foot the credit side. 10,950 5,850

Subtract total credits from total debits to obtain the account balance.
Cash 3,750 4,300 2,900 850 1,400 700 2,900 5,100 10,950 5,850

Transactions and Balance Sheet Accounts

(A) On November 1, Chris Clark deposits $25,000 in a bank account in the name of NetSolutions.
JOURNAL Date Description Debit Credit Page 1 Post Ref. Nov. 1 2005 1 2 3 4 Cash Chris Clark, Capital Invested cash in NetSolutions.

Effects of this entry in the Ledger
(A) On November 1, Chris Clark deposits $25,000 in a bank account in the name of NetSolutions. Effects of this entry in the Ledger Cash Chris Clark, Capital Nov. 1 25,000 Nov. 1 25,000

(B) On November 5, NetSolutions bought land for $20,000, paying cash.
4 5 6 7 8 9 10 5 Land Cash Purchased land for building site.

(B) On November 5, NetSolutions bought land for $20,000, paying cash. Effects of this entry in the Ledger Cash Land Nov. 1 25,000 Nov. 5 20,000 Nov. 5 20,000

(C) On November 10, NetSolutions purchased supplies on account for $1,350.
11 12 13 14 15 16 10 Supplies Accounts Payable Purchased supplies on account.

(C) On November 10, NetSolutions purchased supplies on account for $1,350. Effects of this entry in the Ledger Supplies Accounts Payable Nov. 10 1,350 Nov. 10 1,350

(F) On November 30, NetSolutions paid creditors on account, $950.
31 32 33 34 35 36 30 Accounts Payable Cash Paid creditors on account.

(F) On November 30, NetSolutions paid creditors on account, $950. Effects of this entry in the Ledger Cash Accounts Payable Nov. 1 25,000 Nov. 5 25,000 Nov Nov. 10 1,350 18 7,500 30 3,650 30 950

Rules of Debit / Credit Balance Sheet Accounts
Debits Credits Asset accounts………. Increase (+) Decrease (-) Liability accounts…… Decrease (-) Increase (+) Owner’s equity (capital) accounts…. Decrease (-) Increase (+)

Balance Sheet Accounts
ASSETS Asset Accounts LIABILITIES Liability Accounts Debit for increases (+) Credit for decreases (-) Debit for decreases (-) Credit for increases (+) Owner’s Equity Accounts OWNER’S EQUITY Debit for decreases (-) Credit for increases (+)

(D) On November 18, NetSolutions received fees of $7,500 from customers for services provided .
14 15 16 17 18 19 20 18 Cash Fees Earned Received fees from customers.

(D) On November 18, NetSolutions received fees of $7,500 from customers for services provided . Effects of this entry in the Ledger Cash Fees Earned Nov. 1 25,000 Nov. 5 25,000 Nov. 18 7,500 18 7,500

(E) Throughout the month, NetSolutions incurred the following expenses: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275 . 18 19 20 21 22 23 24 30 Wages Expense Rent Expense Utilities Expense Miscellaneous Expense Cash Paid expenses.

(E) Throughout the month, NetSolutions incurred the following expenses: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275 . Effects of this entry in the Ledger Cash Wages Expense Nov. 1 25,000 Nov. 5 25,000 Nov. 30 2,125 18 7,500 30 3,650 Rent Expense Utilities Expense Nov Nov Miscellaneous Expense Nov

In every entry the sum of the debits always equal the sum of the credits.

(G) On November 30, a count revealed that $800 of the supplies inventory had been used.
25 26 27 28 29 30 31 30 Supplies Expense Supplies Supplies used during November.

(G) On November 30, a count revealed that $800 of the supplies inventory had been used. Effects of this entry in the Ledger Supplies Supplies Expense Nov. 10 1,350 Nov Nov

Double-Entry Accounting
“ Double-entry accounting is based on a simple concept: each party in a business transaction will receive something and give something in return. In bookkeeping terms, what is received is a debit and what is given is a credit. The T account is a representation of a scale or balance.” Scale or Balance T account Left Side Receive DEBIT Right Side Give CREDIT Luca Pacioli Developer of Double-Entry Accounting Receive DEBIT Give CREDIT

Rules of Debit / Credit Income Statement Accounts
Expense Accounts Revenue Accounts Debit for increases (+) Credit for decreases (-) Debit for decreases (-) Credit for increases (+)

Income Statement Accounts
Debits Credits Revenue accounts…… Decrease (-) Increase (+) Expense accounts…… Increase (+) Decrease (-)

Withdrawals by the Owner

(H) On November 30, Chris Clark withdrew $2,000 in cash from NetSolutions for personal use.
JOURNAL Date Description Debit Credit Page 2 Post Ref. Nov. 30 2005 1 2 3 4 Chris Clark, Drawing Cash Chris Clark withdrew cash for personal use.

(H) On November 30, Chris Clark withdrew $2,000 in cash from NetSolutions for personal use. Effects of this entry in the Ledger Cash Chris Clark, Drawing Nov. 1 25,000 Nov. 5 25,000 Nov. 30 2,000 Nov. 10 1,350 18 7,500 30 3,650 30 950 30 2,000

Normal Balances of Accounts
Increase (Normal Balances) Decreases Balance sheet accounts: Asset Debit Credit Liability Credit Debit Owner’s Equity: Capital Credit Debit Drawing Debit Credit Income statement accounts: Revenue Credit Debit Expense Debit Credit

Flow of Business Transactions
1 Transaction authorized 2 Transaction takes place 3 Document prepared 4 Entry recorded in journal 5 Entry posted to ledger

System to Analyze Transactions
1. Determine whether an asset, a liability, owner’s equity, revenue, or expense account is affected by the transaction. 2. For each account affected by the transaction, determine whether the account increases or decreases. 3. Determine whether each increase or decrease should be recorded as a debit or a credit.

Journalizing and Posting

Dec. 1 NetSolutions paid a premium of $2,400 for a comprehensive insurance policy covering two years. JOURNAL Date Description Debit Credit Page 2 Post Ref. Dec. 31 2005 1 2 3 4 Prepaid Insurance Cash Paid premium on two-year policy.

JOURNAL Page 2 Dec. 1 1 2 3 4 Prepaid Insurance 2 400 00 Cash 2 400 00
Date Description Debit Credit Page 2 Post Ref. Dec. 1 2005 1 2 3 4 Prepaid Insurance Cash Paid premium on two-year policy. ACCOUNT Prepaid Insurance ACCOUNT NO. 15 Balance Post. Ref. Date Item Debit Credit Debit Credit Dec. 1 2005

JOURNAL Page 2 Dec. 1 1 2 3 4 Prepaid Insurance 2 400 00 15
Date Description Debit Credit Page 2 Post Ref. Dec. 1 2005 1 2 3 4 Prepaid Insurance 15 Cash Paid premium on two-year policy. ACCOUNT Prepaid Insurance ACCOUNT NO. 15 Balance Post. Ref. Date Item Debit Credit Debit Credit Dec. 1 2005 2

JOURNAL Page 2 1 2 3 4 Dec. 1 Prepaid Insurance 2 400 00 Cash 2 400 00
Post Ref. JOURNAL Date Description Debit Credit Page 2 1 2 3 4 Dec. 1 2005 Prepaid Insurance Cash Paid premium on two-year policy. 15 ACCOUNT Cash ACCOUNT NO. 11 Balance Post. Ref. Date Item Debit Credit Debit Credit Nov. 30 2005 2 Dec. 1

JOURNAL Page 2 1 2 3 4 Dec. 1 Prepaid Insurance 2 400 00 Cash 2 400 00
Post Ref. JOURNAL Date Description Debit Credit Page 2 1 2 3 4 Dec. 1 2005 Prepaid Insurance Cash Paid premium on two-year policy. 15 11 ACCOUNT Cash ACCOUNT NO. 11 Balance Post. Ref. Date Item Debit Credit Debit Credit Nov. 30 2005 2 Dec. 1 2

Dec. 1 NetSolutions paid rent for December, $800.
14 15 16 17 Rent Expense Cash Paid rent for December.

Dec. 1 NetSolutions receives $360 for three month’s rent beginning December 1.
14 15 16 17 Cash Unearned Rent Received advanced payment For three months’ rent of land.

Dec. 4 NetSolutions purchased office equipment on account from Executive Supply Co. for $1,800.
18 19 20 21 Office Equipment Accounts Payable Purchased office equipment on account.

Dec. 6 NetSolutions paid $180 for a newspaper advertisement.
21 22 23 24 Miscellaneous Expense Cash Paid for newspaper ad.

Dec. 11 NetSolutions paid creditors $400.
24 25 26 27 Accounts Payable Cash Paid creditors on account.

Dec. 13 NetSolutions paid a receptionist and part-time assistant $950 for two weeks’ wages.
JOURNAL Date Description Debit Credit Page 3 Post Ref. Dec. 13 2005 1 2 3 4 Wages Expense Cash Paid two week’s wages.

Dec. 16 NetSolutions received $3,100 from fees earned for the first half of December.
5 6 7 8 Cash Fees Earned Received fees from customers.

Dec. 16 Fees earned on account totaled $1,750 for the first half of December.
9 10 11 12 Accounts Receivable Fees Earned Received fees from customers.

Dec. 20. NetSolutions paid $900 to Executive Supply Co
Dec. 20 NetSolutions paid $900 to Executive Supply Co. on the $1,800 debt owed from the December 4 transaction. 20 13 14 15 16 Accounts Payable Cash Paid part of amount owed to Executive Supply Co.

Dec. 21 NetSolutions received $650 from customers in payment of their accounts.
18 19 20 21 Cash Accounts Receivable Received cash from customer on account.

Dec. 23 NetSolutions paid $1,450 for supplies.
22 23 24 25 Supplies Cash Purchased supplies.

Dec. 27 NetSolutions paid the receptionist and part-time assistant $1,200 for two weeks’ wages.
28 29 30 Wages Expense Cash Paid two weeks’ wages.

Dec. 31 NetSolutions paid its $310 telephone bill for the month.
32 33 34 Utilities Expense Cash Paid telephone bill.

Dec. 31 NetSolutions paid its $225 electric bill for the month.
JOURNAL Date Description Debit Credit Page 4 Post Ref. Dec. 31 2005 1 2 3 4 Utilities Expense Cash Paid utility bill.

Dec. 31 NetSolutions received $2,870 from fees earned for the second half of December.
5 6 7 8 Cash Fees Earned Received fees from customers.

Dec. 31 NetSolutions earned $1,120 on account for the second half of December.
9 10 11 12 Accounts Receivable Fees Earned Recorded fees earned on account.

Dec. 31 Chris Clark withdrew $2,000 for personal use.
14 15 16 17 Chris Clark, Drawing Cash Chris Clark withdrew cash for personal use.

Trial Balance

NetSolutions Trial Balance December 31, 2005 Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accounts Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Wages Expense Rent Expense Utilities Expense Supplies Expense Miscellaneous Expense

Balance Sheet Items NetSolutions Trial Balance December 31, 2005
Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accounts Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Wages Expense Rent Expense Utilities Expense Supplies Expense Miscellaneous Expense Balance Sheet Items

Statement of Owner’s Equity Item
NetSolutions Trial Balance December 31, 2005 Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accounts Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Wages Expense Rent Expense Utilities Expense Supplies Expense Miscellaneous Expense Statement of Owner’s Equity Item

Income Statement Items
NetSolutions Trial Balance December 31, 2005 Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accounts Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Wages Expense Rent Expense Utilities Expense Supplies Expense Miscellaneous Expense Income Statement Items

Errors

Errors that will not cause the trial balance to be unequal:
1. Failure to record a transaction or to post a transaction. 2. Recording the same erroneous amount for both the debit and the credit parts of a transaction. 3. Recording the same transaction more than once. 4. Posting a part of a transaction correctly as a debit or credit but to the wrong account.

Correction of Errors Error Correction Procedure Error Correction Procedure 1. Journal entry is incorrect Draw a line through the error but not posted. and insert correct title or amount.

Correction of Errors Error Correction Procedure Error Correction Procedure 1. Journal entry is incorrect Draw a line through the error but not posted. and insert correct title or amount. 2. Journal entry is correct Draw a line through the but posted incorrectly. posted error and post correctly.

Correction of Errors Journal entry is incorrect Journalize and post a
Error Correction Procedure Error Correction Procedure Journal entry is incorrect Journalize and post a and posted correcting entry.

Correcting Errors – An Example
On May 5, a purchase of office equipment on account was incorrectly journalized and posted as shown. Journal – As recorded and posted Date Description Debit Credit May 5 Supplies 12,500 Accounts Payable 12,500 What would be the necessary correcting entry?

On May 5, a purchase of office equipment on account was incorrectly journalized and posted as shown. Journal – As recorded and posted Date Description Debit Credit May 5 Supplies 12,500 Accounts Payable 12,500 Date Description Debit Credit May 5 Office Equipment 12,500

On May 5, a purchase of office equipment on account was incorrectly journalized and posted as shown. Journal – As recorded and posted Date Description Debit Credit May 5 Supplies 12,500 Accounts Payable 12,500 Date Description Debit Credit May 5 Office Equipment 12,500 Supplies 12,500

Financial Analysis and Interpretation
Comparing an item in a current statement with the same item in prior statements is called horizontal analysis.

Supplies expense 2,700 3,000 (300) (10.0)%
J Holmes, Attorney-at-Law Income Statement For the Year Ended December 31, 2005 and 2006 Increase (Decrease) Amount Percent Fees earned $187,500 $150,000 $37, % Operating expenses: Wages expense $ 60,000 $ 45,000 $15, % Rent expense 15,000 12,000 3, % Utilities expense 12,500 9,000 3, % Supplies expense 2,700 3,000 (300) (10.0)% Misc. expense , , % Total operating expenses $ 92,500 $ 70,800 $21, % Net income $ 95,000 $ 79,200 $15, %

Chapter 2 The End

Analyzing Transactions

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