2. 2-2
C1
ANALYZING AND RECORDING
PROCESS
Analyze each transaction and Record relevant transactions
event from source documents and events in a journal
Prepare and analyze Post journal information
the trial balance to ledger accounts
3. 2-3
C1
SOURCE DOCUMENTS
Bills from
Checks Suppliers Purchase
Orders
Employee
Earnings
Records Bank
Statements
Sales
Tickets
4. 2-4
C2 THE ACCOUNT AND ITS
ANALYSIS
An account is a
An account is a
record of
record of
increases and The general
The general
increases and ledger is a record
decreases in a
decreases in a ledger is a record
specific asset, containing all
containing all
specific asset, accounts used by
liability, equity,
liability, equity, accounts used by
revenue, or the company.
the company.
revenue, or
expense item.
expense item.
5. 2-5
C2 THE ACCOUNT AND ITS
ANALYSIS
Owner, Capital
Owner, Capital
Owner, Withdrawals
Owner, Withdrawals
8. 2-8
C2
EQUITY ACCOUNTS
Owner’s
Owner’s Owner’s
Owner’s
Capital
Capital Withdrawals
Withdrawals
Equity
Accounts
Revenues
Revenues Expenses
Expenses
9. 2-9
C2 THE ACCOUNT AND ITS
ANALYSIS
Assets = Liabilities + Equity
10. 2 - 10
C3
LEDGER AND CHART OF
ACCOUNTS
The ledger is a collection of all accounts for an
The ledger is a collection of all accounts for an
information system. A company’s size and diversity
information system. A company’s size and diversity
of operations affect the number of accounts needed.
of operations affect the number of accounts needed.
The chart of accounts is a list of all accounts and includes an
identifying number for each account.
Account Number Account Name Account Number Account Name
101 Cash 302 C. Taylor, Withdrawals
106 Accounts receivable 403 Revenues
126 Supplies 406 Rental revenue
128 Prepaid insurance 622 Salaries expense
167 Equipment 637 Insurance expense
201 Accounts payable 640 Rent expense
236 Unearned revenue 652 Supplies expense
301 C. Taylor, Capital 690 Utilities expense
11. 2 - 11
C4
DEBITS AND CREDITS
A T-account represents a ledger account and
is a tool used to understand the effects of
one or more transactions.
Account Title
(Left side) (Right side)
Debit Credit
12. 2 - 12
C4
DOUBLE-ENTRY ACCOUNTING
Assets = Liabilities + Equity
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
+ - - + - +
Normal
Normal Normal
Normal Normal
Normal
16. 2 - 16
P1 JOURNALIZING
TRANSACTIONS
Transaction
Transaction Titles of Affected
Titles of Affected
Date
Date Accounts
Accounts
Date Description Debit Credit
2011
Dec. 1 Cash 30,000
C. Taylor, Capital 30,000
Investment by owner
Dec. 2 Supplies 2,500
Cash 2,500
Purchased supplies for cash
Transaction
Transaction Dollar amount of debits
Dollar amount of debits
explanation
explanation and credits
and credits
17. 2 - 17
P1
BALANCE COLUMN ACCOUNT
T-accounts are useful illustrations, but balance
column ledger accounts are used in practice.
18. 2 - 18
P1
POSTING JOURNAL ENTRIES
2011
Dec. 1 Cash 30,000
C. Taylor, Capital 30,000
Investment by owner
1 Identify the debit account in ledger.
19. 2 - 19
P1
POSTING JOURNAL ENTRIES
2011
Dec. 1 Cash 30,000
C. Taylor, Capital 30,000
Investment by owner
2 Enter the date.
20. 2 - 20
P1
POSTING JOURNAL ENTRIES
2011
Dec. 1 Cash 30,000
C. Taylor, Capital 30,000
Investment by owner
3 Enter the amount and description.
21. 2 - 21
P1
POSTING JOURNAL ENTRIES
2011
Dec. 1 Cash 30,000
C. Taylor, Capital 30,000
Investment by owner
4 Enter the journal reference.
22. 2 - 22
P1
POSTING JOURNAL ENTRIES
2011
Dec. 1 Cash 30,000
C. Taylor, Capital 30,000
Investment by owner
5 Compute the balance.
23. 2 - 23
P1
POSTING JOURNAL ENTRIES
2011
Dec. 1 Cash 101 30,000
C. Taylor, Capital 30,000
Investment by owner
6 Enter the ledger reference.
24. 2 - 24
A1
ANALYZING TRANSACTIONS
Analysis:
Posting:
Cash 101 C. Taylor, Capital 301 301
(1) 30,000 (1) 30,000
29. 2 - 29
P2 After processing its remaining transactions for
December, FastForward’s Trial Balance is prepared.
FastForward
Trial Balance The trial balance
December 31, 2011 lists all account
Debits Credits balances in the
Cash $ 4,350
Accounts receivable - general ledger. If
Supplies 9,720 the books are in
Prepaid Insurance 2,400
Equipment 26,000 balance, the total
Accounts payable $ 6,200 debits will equal the
Unearned consulting revenue 3,000
C. Taylor, Capital 30,000 total credits.
Owner's Withdrawals 200
Consulting revenue 5,800
Rental revenue 300
Salaries expense 1,400
Rent expense 1,000
Utilities expense 230
Total $ 45,300 $ 45,300
30. PREPARING A TRIAL
2 - 30
P2
BALANCE
Preparing a trail balance involves three steps:
1. List each account title and its amount (from
ledger) in the trial balance. If an account has
a zero balance, list it with a zero in the
normal balance column (or omit it entirely).
2. Compute the total of debit balances and the
total of credit balances.
3. Verify (prove) total debit balances equal total
credit balances.
31. 2 - 31
P2
SEARCHING FOR AND
CORRECTING ERRORS
If the trial balance does not balance, the
error(s) must be found and corrected.
Make sure the trial Re-compute each
balance columns are account balance in the
correctly added. ledger.
Make sure account Verify that each journal
balances are correctly entry is posted correctly.
entered from the ledger.
See if debit or credit Verify that each original
accounts are mistakenly journal entry has equal
placed on the trial balance. debits and credits.
32. 2 - 32
P3
USING A TRIAL BALANCE TO PREPARE
FINANCIAL STATEMENTS
33. 2 - 33
P3
INCOME STATEMENT
FASTFORWARD
Income Statement
For the Month Ended December 31, 2011
Revenues:
Consulting revenue $ 5,800
Rental revenue 300
Total revenues $ 6,100
Expenses:
Rent expense 1,000
Salaries expense 1,400
Utilities expense 230
Total expenses 2,630
Net income $ 3,470
34. 2 - 34
P3
STATEMENT OF OWNER'S EQUITY
FASTFORWARD
Statement of Owner's Equity
For the Month Ended December 31, 2011
C. Taylor, Capital 12/1/11 $ -
Net income for December 3,470
Connections Plus: Investments by Owner 30,000
33,470
Less: Owner Withdrawals 200
C. Taylor, Capital, 12/31/11 $ 33,270
FASTFORWARD
Income Statement
For the Month Ended December 31, 2011
Revenues:
Consulting revenue $ 5,800
Rental revenue 300
Total revenues $ 6,100
Expenses:
Rent expense 1,000
Salaries expense 1,400
Utilities expense 230
Total expenses 2,630
Net income $ 3,470
35. 2 - 35
P3
BALANCE SHEET
FASTFORWARD
Statement of Owner's Equity
For the Month Ended December 31, 2011
FASTFORWARD
C. Taylor, Capital 12/1/11 $ -
Balance Sheet
December 31, 2011
Net income for December 3,470
Assets
Plus: Investments by Owner 30,000
Cash $ 4,350
33,470
Supplies 9,720
Less: Owner Withdrawals 200
Prepaid insurance 2,400
C. Taylor, Capital, 12/31/11 $ 33,270
Equipment 26,000
Total assets $ 42,470
Liabilities
Accounts payable $ 6,200
Connections
Unearned revenue 3,000
Total liabilities 9,200
Equity
C. Taylor, Capital $ 33,270
Total equity 33,270
Total liabilities and equity $ 42,470
36. 2 - 36
P3
PRESENTATION ISSUES
1. Dollar signs are not used in journals and ledgers.
2. Dollar signs appear in financial statements and other
reports such as trial balances. The usual practice is to
put dollar signs beside only the first and last numbers
in a column.
3. When amounts are entered in the journal, ledger, or
trial balance, commas are optional to indicate
thousands, millions, and so forth.
4. Commas are always used in financial statements.
5. Companies commonly round amounts in reports to the
nearest dollar, or even to a higher level.
37. 2 - 37
GLOBAL VIEW
Both U.S. GAAP and IFRS prepare the same four basic financial
statements. A few differences are found within each statement, but
over time these differences are likely to be eliminated. Here is a typical
IFRS balance sheet presentation:
38. 2 - 38
ACCOUNTING CONTROLS AND
ASSURANCE
Accounting systems depend on control procedures that
Accounting systems depend on control procedures that
assure the proper principles were applied in processing
assure the proper principles were applied in processing
accounting information. The passage of SOX legislation
accounting information. The passage of SOX legislation
strengthened U.S. control procedures in recent years.
strengthened U.S. control procedures in recent years.
The percentage of employees in information technology that
report observing specific types of misconduct in 2009.
39. 2 - 39
A2
Debt Ratio
Total Liabilities
Debt Ratio =
Total Assets
Evaluates the level of debt risk.
A higher ratio indicates that there is a
greater probability that a company will
not be able to pay it’s debt in the future.
We begin the accounting process by analyzing source documents. For example, you usually receive a receipt when you pay cash for something. Think about the last time you went to a fast food restaurant. When you received your order, you were given a receipt, a source document. If you wanted a company to reimburse you for the meal because you were traveling on company business, you must present evidence of your expenditure. This evidence takes the form of a source document, the receipt. Once we identify a business transaction, we record it in a journal . A journal is arranged in chronological order. Transactions are recorded by date of occurrence. At the end of the accounting period, usually a month, transactions in the journal are posted to a ledger account. Posting is the systematic process of transferring information from the journal to the ledger. The ledger groups transactions by the accounts impacted. For example, we will have a ledger account for cash. All transactions that result in increases or decreases in the cash account will be posted to the cash ledger account. Once all transactions have been posted, we prepare a trial balance . The purpose of the trial balance is to make sure that all information has been transferred properly. The trial balance is a listing of all account balances.
Source documents identify and describe transactions and events entering the accounting process. They are the sources of accounting information and can be in either hard copy or electronic form. Almost all businesses use sales orders, purchase orders, statements from suppliers, canceled checks, bank statements, shipping notices, packing slips, and the like to support the existence of a transaction. In today’s highly computerized environment, many source documents are stored digitally. Knowing how to access these digital source documents is an important part of accounting.
Let’s define accounts and the general ledger. An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item. The general ledger is a record containing all accounts used by the company.
Recall the basic accounting equation – Assets are equal to Liabilities plus Equity. The equity section is composed of the owner’s capital account and the owner’s withdrawal account. Asset accounts – Assets are resources owned or controlled by a company and that have expected future benefits. Most accounting systems include (at a minimum) separate accounts for the assets described, such as, cash, accounts receivable, note receivable, and prepaid accounts. Liability accounts – Liabilities are claims (by creditors) against assets, which means they are obligations to transfer assets or provide products or services to other entities. Creditors often use a balance sheet to help decide whether to loan money to a company. A loan is less risky if the borrower’s liabilities are small in comparison to assets because this means there are more resources than claims on resources. Equity Accounts – The owner’s claim on a company’s assets is called equity or owner’s equity. Equity is the owner’s residual interest in the assets of a business after deducting liabilities.
Here is a listing of common asset accounts we are likely to find in all businesses. Prepaid accounts may be new to you. Think about your auto insurance. Many of us pay our auto insurance semi-annually or annually. The payment is made in advance and is referred to as a prepaid amount. Prepaid amounts will turn into expenses as they are used up.
This is a listing of common liability accounts we are likely to see in the general ledger. An unearned revenue is one in which the cash has been received but the product or service has not been delivered. If you subscribe to a magazine, you generally pay a one-year subscription in advance. For the publishing company, cash is received but nothing has been done to earn the revenue. As the magazine is delivered to you, the publishing company recognizes a portion of the money received as revenue. At the end of the year, all the revenue will be earned and the liability no longer exists.
The owner’s claim on a company’s assets is called equity. Equity is the owner’s residual interest in the assets of a business after deducting liabilities. Equity is impacted by four types of accounts: Owner’s capital, Owner’s withdrawals, Revenues, and Expenses.
Do you remember the expanded accounting equation we used to record transactions in Chapter 1? Remember that revenues increase the equity side of the equation and expenses decrease equity. In addition, owner’s contributions increase equity and owner’s withdrawal decrease equity.
The ledger is a collection of all accounts for an information system. A company’s size and diversity of operations affect the number of accounts needed. A chart of accounts is a listing of all accounts in the ledger and each account includes an identifying number. Notice that all assets accounts begin with an account number of one, all liabilities with two, equities with three, revenues with four, and expenses with six.
Accountants often use a T-account to represent a general ledger account. It is a quick way to analyze transactions before we enter the information in the journal. The account title is entered on the top of the T-account. The left side of a T-account is always called the debit side, and the right side is always called the credit side. This terminology comes from the time when the first double-entry system was developed. We still use the terms as a convention. The words do not have any significant meaning other than that they stand for the left and right side of a ledger. When the sum of the debits exceed the sum of the credits in a particular account, the account has a debit balance.
Double-entry accounting requires that for each transaction: ● At least two accounts are involved, with at least one debit and one credit. ● The total amount debited must equal the total amount credited. ● The accounting equation must not be violated. After we decide on the terms to use for the left and right side of a ledger account, we must establish the mathematics of the double-entry system. Liabilities and equity have the opposite sign of assets. If we were to move the liabilities to the left side of the equation, it would read assets minus liabilities equal equity. As a convention of double-entry accounting we have decided that a debit, or left side, to an asset account will represent an increase in the asset account balance. Once this decision is made, all the remaining math is determined. Because liabilities and equity have the opposite sign of assets, a debit to a liability or equity account means a decrease and a credit means an increase. Instead of using the terms increase and decrease, we use the terms debit and credit. It is important to remember whether we are talking about an asset, liability, or equity account for the meaning of a debit or a credit. Another method for working with debits and credits is to use the accounting equation as a guide. Assets are on the left hand side of the accounting equation. Therefore all increases to assets are on the debit (left) side of the T-account. Liabilities and equity accounts are on the right hand side of the accounting equation. Therefore all increases to liabilities and equity accounts are on the credit (right) side of the T-account. It will take you a short while to become accustomed to using the terms debit and credit, but with practice you will master the concept easily.
Here is the expanded accounting equation showing the equity section. Because revenues increase equity, a revenue account must be recorded just like the C. Taylor, Capital account. A credit is an increase in revenues and a debit is an increase in expenses. The C. Taylor, Capital and revenue accounts are both increased with a credit and decreased with a debit. Owner's Withdrawals and expenses have an opposite sign, so these accounts are increased with a debit and decreased with a credit.
We have determined the balance in accounts in the last chapter, but in this chapter we will look at a more comprehensive way to determine an account balance. The cash account is an asset, so increases, or receipts, are shown on the debit, or left side, and decreases, or payments, are shown on the credit side, or right side. To determine if an account has a debit or credit balance, we total the right and left sides and place the balance on the larger side. In this example, our increases in cash amount to $36,100 and the decreases total $31,300 so the cash account has a debit, or positive balance of $4,800.
In the accounting process, you first analyze a transaction by looking at proper source documentation. Next, we apply the rules of double-entry accounting and record a general journal entry. The general journal is a chronological listing of the transactions. At the end of the accounting period, we post the information from the general journal to the proper general ledger account. The general ledger groups all transactions that impact a particular account. That is, all the transactions that increase or decrease the cash account are posted to the general ledger cash account.
Here is an example of the proper recording of a general journal transaction. We have seen a similar transaction before. In this case, the owner of the business contributes $30,000 cash to start the business. Let’s see how we get the various pieces. The transaction occurred on December 1st, 2011. The date is important when recording general journal transactions and is recorded on the left side of the journal. Next we identify the accounts affected by the transactions. The cash account is an asset that has increased. We show increases in asset accounts with a debit to that account. The C. Taylor, Capital account also increased and we show increases in equity accounts with a credit. Debits are always listed first in the journal followed by credits that are slightly indented below the debits. The dollar amount is placed in the appropriate debit or credit column. In this case, the cash account was debited for $30,000, so we place that amount in the debit column. Finally, we prepare a brief description of the transaction so that other people who view our work will understand the nature of the transaction. This explanation is indented about as far as the credited account titles to avoid confusing it with accounts and it is italicized.
T-accounts are useful illustrations, but balance column ledger accounts are used in practice. The balance column account format is similar to a T-account in having columns for debits and credits. It is different in including transaction date and explanation columns. It also has a column with the balance of the account after each entry is recorded. The Cash account is debited on December 1 for the $30,000 owner investment, yielding a $30,000 debit balance. The account is credited on December 2 for $2,500, yielding a $27,500 debit balance. On December 3, it is credited again, this time for $26,000, and its debit balance is reduced to $1,500. The Cash account is debited for $4,200 on December 10, and its debit balance increases to $5,700; and so on.
Let’s look at the posting process. We will transfer or “post” the information from the general journal to the proper ledger account. This process is called posting . First, we find the proper account in the general ledger. In our example, we used the cash account.
We transfer the date, December first, to the date column in the general ledger.
We place a description in the description column and place the debit amount of $30,000 in the debit column of the general ledger cash account.
Next, we indicate where you can find the journal entry. In our case, it is on the first page of the general journal. We use the letter “G” to indicate general journal and the number 1 to represent the page number.
Now, we update the running balance in the cash account.
Back in the general journal, we enter a posting reference of the account number in the proper column. This tells the accountant that the amount has been posted to account number 101. Now we can go back and forth between the general journal and the general ledger. This is known as a cross-reference. We would follow the same procedures for the capital account. Let’s begin using the double-entry accounting system.
Let’s see if we can analyze transactions and get them into the proper form for double-entry accounting. This will be helpful when you turn to your homework. In the first transaction, on December first, the owner invests $30,000 to start a company called FastForward. From our previous work, we know that the cash account and the C. Taylor, Capital account will increase. We record this information in the general journal with a debit, increase, to cash, and a credit, increase, to C. Taylor, Capital. Notice that the account number for the cash account is 101 and C. Taylor, Capital is 301. We are going to post the information in the journal to the general ledger. We will use T-accounts to accomplish this. We place the $30,000 on the left, or debit, side of the cash account and on the right, or credit, side of the C. Taylor, Capital account. Our books are in balance because total assets are equal to total liabilities plus equity. Let’s move to another transaction.
In our second transaction, FastForward purchases office supplies paying $2,500 cash. We have exchanged one asset, cash, for another asset, supplies. The cash account will decrease and the supplies account will increase. Can you make the general journal entry to record this transaction? We increase the supplies account with a debit and decrease the asset account, cash, with a credit. Let’s post the amounts. The general ledger account for supplies increased by $2,500 so the amount is placed on the debit side of the account. The cash account, an asset, decreased by $2,500, so the amount is placed on the credit side of the general ledger account. Let’s move on to another transaction.
In our third transaction, FastForward purchases equipment paying $26,000 cash. Once again, we have exchanged one asset, cash, for another asset, equipment. The cash account will decrease and the equipment account will increase. This general journal entry will look similar to the one we just completed. We increase the equipment account with a debit and decrease the asset account, cash, with a credit. Let’s post the amounts. The general ledger account for equipment increased by $26,000 so it is placed on the debit side of the account. The cash account, an asset, decreased by $26,000, so the amount is placed on the credit side of the general ledger account. Let’s look at another transaction.
In this transaction, FastForward purchases $7,100 of office supplies on account. The supplies account, an asset, will increase and the liability account, accounts payable will increase. Let’s make the general journal entry to record this transaction. We increase the supplies account with a debit and increase the liability account, accounts payable, with a credit. It is time to post the transaction. The general ledger account for supplies increased by $7,100 so the amount is placed on the debit side of the account. The accounts payable account, a liability, increased by the same amount, so we place it on the credit side of the general ledger account. Let’s analyze another transaction.
FastForward provided consulting services and collected $4,200 cash. The asset account, cash, increased by $4,200 and the equity account, consulting revenue, increased by the same amount. See if you can make the general journal entry to record this transaction before moving to the next slide. We increase the cash account with a debit and increase the revenue account, consulting revenue, with a credit. Let’s post the amounts. The general ledger account for cash increased by $4,200 so the amount is placed on the debit side of the account. The consulting revenue account increased by the same amount, so it is placed on the credit side of the general ledger account. We could continue on with more transactions, but your homework will help reinforce what we have done here. Let’s take a look at the trial balance of FastForward at the end of December.
On the trial balance, we list all the accounts in our general ledger and their related balances. The total of all our debit account balances must equal all our credit account balances. If this is not the case, we may have made an error posting the journal entry into the ledger. We cannot prepare the financial statement until the books are in balance as determined by the trial balance.
Preparing a trail balance involves three steps: List each account title and its amount (from ledger) in the trial balance. If an account has a zero balance, list it with a zero in the normal balance column (or omit it entirely). Compute the total of debit balances and the total of credit balances. Verify (prove) total debit balances equal total credit balances. The total of debit balances equals the total of credit balances for the trial balance. However, equality of these two totals does not guarantee that no errors were made.
If the trial balance does not balance, the error(s) must be found and corrected. Step 1 verify that the trial balance columns are correctly added. Step 2 verify that account balances are accurately entered from the ledger. Step 3 see whether a debit (or credit) balance is mistakenly listed in the trial balance as a credit (or debit). Step 4 re-compute each account balance in the ledger. Step 5 verify that each journal entry is properly posted. Step 6 is to verify that the original journal entry has equal debits and credits.
As we have seen in the last chapter, after the trial balance has been prepared we begin preparing the financial statements. We always begin with the income statement because net income appears on the statement of owner's equity. After the income statement, we prepare the statement of owner's equity because the ending balance in owner's equity appears on the balance sheet. Next, we prepare the balance sheet and finally, we prepare the statement of cash flows.
Here is the information for FastForward for the month ended December 31, 2011. The company had total revenues of $6,100 and total expenses of $2,630. For the month, FastForward generated $3,470 in net income. Look back at our trial balance to verify the amounts shown on the income statement.
The beginning balance in owner's equity was zero because the company was started on December 1, 2011. We earned net income of $3,470. (This is the total carried over from the income statement.) During the month, the owner invested $30,000 bringing the subtotal of the equity to $33,470. Owner's withdrawals of $200 were paid. So the ending balance in owner's equity is $33,270. This amount will appear on the equity section of the balance sheet. Let’s look at the balance sheet now.
Total assets equal $42,470. Total liabilities are $9,200 and our equity balance is $33,270. The accounting equation is in balance because assets are equal to liabilities plus equity.
There are many common standards for formatting in accounting. Here are some standards used by most companies: Dollar signs are not used in journals and ledgers. Dollar signs appear in financial statements and other reports such as trial balances. The usual practice is to put dollar signs beside only the first and last numbers in a column. When amount are entered in the journal, ledger, or trial balance, commas are optional to indicate thousands, millions, and so forth. Commas are always used in financial statements. Companies commonly round amounts in reports to the nearest dollar, or even to a higher level.
Both U.S. GAAP and IFRS require balance sheets to separate current items from noncurrent items. However, U.S. GAAP balance sheets report current items first, while IFRS balance sheets normally (but are not required to) present noncurrent items first, and equity before liabilities.
Accounting systems depend on control procedures that assure the proper principles were applied in processing accounting information. The passage of SOX legislation strengthened U.S. control procedures in recent years. However, global standards for control are diverse and so are enforcement activities. Consequently, while global accounting standards are converging, their application in different countries can yield different outcomes depending on the quality of their auditing standards and enforcement.
Debt Ratio Analysis Borrowing money is risky business. The debt to assets ratio helps evaluate the level of debt risk. We determine a company’s ability to pay it’s debts (liabilities) using the debit ratio. The debt ratio is equal to total liabilities divided by total assets. A higher ratio indicates that there is greater probability a company will not be able to pay it’s debts in the future.
