Principles of Accounting I

CHAPTER 2: ANALYZING TRANSACTION

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 Chapter’s objectives
After studying this chapter, students should be able to:
✔ Describe the nature of the adjusting process: the adjusting process, types
of accounts requiring adjustment
✔ Journalize entries for accounts requiring adjustment: Prepaid Expenses,
Unearned Revenues, Accrued Revenues, Accrued Expenses, Depreciation
Expense
✔ Summarize the adjustment process
✔ Prepare an adjusted trial balance
✔ Describe and illustrate the use of vertical analysis in evaluating a company’s
performance and financial condition.

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1. Using accounts to record transactions

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1. Using accounts to record transactions

Accounting systems are designed to show the changes in each accounting

equation element as a separate record. This record is called an account.

❑ An account (simplest form) has three parts - T account

1. A title, which is the name of the accounting equation element recorded
in the account.
2. A space for recording increases in the amount of the element.
3. A space for recording decreases in the amount of the element

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1. Using accounts to record transactions

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1. Using accounts to record transactions

❑ Recording transactions in accounts must follow certain rules:

• Increases in assets are recorded on the debit of an account.
• Decreases in assets are recorded on the credit of an account.
• The excess of the debits of an asset account over its credits is the balance
of the account

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1. Using accounts to record transactions
❑ Chart of accounts

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

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

• The accounts are normally listed in the order in which they appear in the
financial statements:
1. The balance sheet accounts: assets, liabilities, and owner’s equity
2. The income statement accounts: revenues and expenses.

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1. Using accounts to record transactions
❑ Chart of accounts
A chart of accounts should meet the needs of a company’s managers and
other users of its financial statements. The accounts within the chart of
accounts are numbered for use as references. A numbering system is normally
used, so that new accounts can be added without affecting other account
numbers.

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1. Using accounts to record transactions
❑ Chart of accounts

Assets are resources owned by the business entity under physical or intangibles
items that have value. Assets also include accounts receivable, prepaid expenses
(such as insurance), buildings, equipment, and land.

Liabilities are debts owed to outsiders (creditors). Liabilities are often identified
by payable.

Owner’s equity is the owner’s right to the assets of the business after all
liabilities have been paid.

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1. Using accounts to record transactions
❑ Chart of accounts

Revenues are increases in owner’s equity as a result of selling services or

products to customers. Revenues include fees earned, fares earned, commissions
revenue, and rent revenue

Expenses result from using up assets or consuming services in the process of

generating revenues.

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1. Using accounts to record transactions
❑ Chart of accounts
Current Assets
Cash and other assets that are expected to be converted into cash or sold or
used up usually within one year or less, through the normal operations of the
business, are called current assets.
Current assets include:
Cash
Accounts receivable
Notes receivable
Supplies
Other prepaid expenses

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1. Using accounts to record transactions
❑ Chart of accounts
Current Assets
Notes receivable are written promises by the customer to pay the amount of
the note and interest. Like accounts receivable, notes receivable are amounts
that customers owe, but they are more formal than accounts receivable.
Notes receivable and accounts receivable are current assets because they are
usually converted to cash within one year or less.

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1. Using accounts to record transactions
❑ Chart of accounts
Property, Plant, and Equipment
Property, plant, and equipment (also called fixed assets or plant assets or
non-current assets) include land and assets that depreciate over a period of
time.
Assets that depreciate over time include:
Equipment
Machinery
Buildings

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1. Using accounts to record transactions
❑ Chart of accounts
Current Liabilities
Amounts the business owes to creditors that will be due within a short time
(usually one year or less) and that are to be paid out of current assets are
called current liabilities.
Current liabilities include:
Accounts payable
Notes payable
Wages payable
Interest payable
Unearned fees

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1. Using accounts to record transactions
❑ Chart of accounts
Non-current Liabilities
Amounts the business owes to creditors that will not be due for a long time
(usually more than one year) are called non-current liabilitites or long-term
liabilities.

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1. Using accounts to record transactions
❑ Chart of accounts
Exercise: Identify weather the following accounts would be reported in the (a)
current asset; (b) property, plant, and equipment; (c) current liability; (d)
long-term liability; or (e) owners’ equity section.
1. Common Stock
2. Notes Receivable (due in six months)
3. Notes Payable (due in 10 years)
4. Land
5. Cash
6. Unearned Rent (three months)
7. Accumulated Depreciation—Equipment
8. Accounts Payable
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1. Using accounts to record transactions
❑ Chart of accounts
Exercise: Identify weather the following accounts would be reported in the (a)
current asset; (b) property, plant, and equipment; (c) current liability; (d)
long-term liability; or (e) owners’ equity section.
1. Common Stock 1. Stockholders’ equity
2. Notes Receivable (due in six months) 2. Current asset
3. Notes Payable (due in 10 years) 3. Long-term liability
4. Land 4. Property, plant, and equipment
5. Cash 5. Current asset
6. Unearned Rent (three months) 6. Current liability
7. Accumulated Depreciation—Equipment 7. Property, plant, and equipment
8. Accounts Payable 8. Current liability
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2. Double-entry accounting system

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2. Double-entry accounting system
❑ Balance sheet account

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2. Double-entry accounting system
❑ Income statement account

❑ Owner withdrawals

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2. Double-entry accounting system
❑ Normal balance
The sum of the increases in an account is usually equal to or greater than the
sum of the decreases in the account. Thus, the normal balance of an account
is either a debit or credit depending on whether increases in the account are
recorded as debits or credits.
• Debits (Debere): Dr.
• Credit (Cebere): Cr.
• When an account normally having a debit balance has a credit balance, or
vice versa

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2. Double-entry accounting system
❑ Normal balance

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2. Double-entry accounting system
❑ Normal balance

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2. Double-entry accounting system
❑ Normal balance

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2. Double-entry accounting system
❑ Journalizing

Transactions are initially entered in a record called a journal.

The process of recording a transaction in the journal is called journalizing

The entry in the journal is called a journal entry.

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2. Double-entry accounting system
❑ Journalizing
• Recording transaction in journal steps
Useful method for analyzing and journalizing transactions:

Determine
Carefully read
the account
transaction &
increases or
determine
decreases
affected acc.

Record the Determine a

transaction debit or
using a a credit
journal entry
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2. Double-entry accounting system
❑ Journalizing
• Recording transaction in journal steps
Step 1. The date of the transaction: in the Date column.
Step 2. The title of the debited account: left-hand under the Description column
The amount: Debit column.
Step 3. The title of the credited account: below, to the right of the debited account
The amount: Credit column.
Step 4. A brief description may be entered below the credited account.
Step 5. The Post. Ref. (Posting Reference) column is left blank when the journal entry
is initially recorded. This column is used later in this chapter when the journal entry
amounts are transferred to the accounts in the ledger.

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2. Double-entry accounting system
❑ Journalizing
• Recording transaction in journal steps

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2. Double-entry accounting system
❑ Journalizing
• Example 1:

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2. Double-entry accounting system
❑ Journalizing
• Example 1:

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2. Double-entry accounting system
❑ Journalizing
• Example 2:

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2. Double-entry accounting system
❑ Journalizing
• Example 2:

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2. Double-entry accounting system
❑ Journalizing
• Example 3:

Date Descript. Debit Credit

Nov 18. 2013 Cash 7,500

Fee Earned 7500
Provided service for customer

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2. Double-entry accounting system
❑ Journalizing
• Example 3:

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2. Double-entry accounting system
❑ Journalizing
• Example 3:

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2. Double-entry accounting system
❑ Journalizing

Date Descript. Debit Credit

June 3 Truck 42,500

2021 Cash 8,500
Account Payable 34,000
Purchase truck

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2. Double-entry accounting system
❑ Journalizing

Chapter 2 38
3. Posting journal entry to account

Periodically, transfer to
Record transaction in journal
accounts in ledger.

The process of transferring the debits and credits from the journal entries to
the accounts is called posting.

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3. Trial balance

1. Transactions are analyzed

and recorded in journal.
Documents
Journal

2. Transactions are posted

from journal to ledger.
Journal Ledger

3. Trial balance is prepared.

Trial Balance

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3. Trial balance

Trial balance is a tool to detect errors occur in posting debits and credits from
the journal to the ledger.

Step 1. List the name of the company, the title of the trial balance, and the date
the trial balance is prepared

Step 2. List the accounts from the ledger, and enter their debit or credit
balance in the Debit or Credit column of the trial balance

Step 3. Total the Debit and Credit columns of the trial balance

Step 4. Verify that the total of the Debit column equals the total of the Credit
column

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3. Trial balance

General Journal Page 1

Post.
Date Description Ref. Debit Credit
12/1Prepaid Insurance 2,400
Cash 2,400

1. Analyze and record the transaction as shown.

2. Post the debit side of the transaction.
3. Post the credit side of the transaction.

Recording and Posting an Entry

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3. Trial balance
General Journal Page 1
Post.
Date Description Ref. Debit Credit
12/1Prepaid Insurance 2,400
Cash 2,400
1 General Ledger
Account: Prepaid Insurance Account No. 15
Post. Balance
Date Item Ref. Debit Credit Debit Credit
12/1

1 Enter the transaction date in the ledger account.

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3. Trial balance
General Journal Page 1
Post.
Date Description Ref. Debit Credit
12/1Prepaid Insurance 15 2,400
Cash 2,400

General Ledger 2

Account: Cash Account No.1

Post. Balance
Date Item Ref. Debit Credit Debit Credit
12/1 1 2400

2 Enter the debit amount in the ledger debit column.

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3. Trial balance
General Journal Page 1
Post.
Date Description Ref. Debit Credit
12/1Prepaid Insurance 2,400
Cash 2,400

General Ledger
Account: Prepaid Insurance Account No. 15
Post. Balance
Date Item Ref. Debit Credit Debit Credit
12/1 1 2,400 2,400
3

3 Update the ledger account balance.

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3. Trial balance
General Journal Page 1
Post.
Date Description Ref. Debit Credit
12/1Prepaid Insurance 2,400
Cash 2,400

General Ledger 4

Account: Prepaid Insurance Account No. 15

Post. Balance
Date Item Ref. Debit Credit Debit Credit
12/1 1

4 Enter the journal page in the ledger account.

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3. Trial balance
General Journal Page 1
Post.
Date Description Ref. Debit Credit
12/1Prepaid Insurance 15 2,400
Cash 2,400
5
General Ledger
Account: Prepaid Insurance Account No. 15
Post. Balance
Date Item Ref. Debit Credit Debit Credit
12/1 1 2,400 2,400

5 Enter the ledger account number in the journal.

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3. Trial balance
General Journal Page 1
Post.
Date Description Ref. Debit Credit
12/1Prepaid Insurance 15 2,400
Cash 11 2,400
1 4 5 2
General Ledger
Account: Cash Account No. 11
Post. Balance
Date Item Ref. Debit Credit Debit Credit
11/30 Balance 5,900
12/1 1 2,400 3,500
3

All five parts of the credit posting are shown.

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3. Trial balance
❑ Errors Affecting the Trial balance
1. If the difference between the Debit and Credit column totals is 10, 100, or
1,000, an error in addition may have occurred. In this case, re-add the trial
balance column totals. If the error still exists, recompute the account balances.
2. If the difference between the Debit and Credit column totals can be evenly
divisible by 2, the error may be due to the entering of a debit balance as a credit
balance, or vice versa. In this case, review the trial balance for account balances
of one-half the difference that may have been entered in the wrong column. For
example, if the Debit column total is $20,640 and the Credit column total is
$20,236, the difference of $404 ($20,640 - $20,236) may be due to a credit
account balance of $202 that was entered as a debit account balance.

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3. Trial balance
❑ Errors Affecting the Trial balance
3. If the difference between the Debit and Credit column totals is evenly divisible
by 9, trace the account balances back to the ledger to see if an account balance
was incorrectly copied from the ledger. Two common types of copying errors are
transpositions and slides. A transposition occurs when the order of the digits is
copied incorrectly, such as writing $542 as $452 or $524.
4. If the difference between the Debit and Credit column totals is not evenly divisible
by 2 or 9, review the ledger to see if an account balance in the amount of the error
has been omitted from the trial balance. If the error is not discovered, review the
journal postings to see if a posting of a debit or credit may have been omitted.
5. If an error is not discovered by the preceding steps, the accounting process must
be retraced, beginning with the last journal entry.
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3. Trial balance
❑ Errors Affecting the Trial balance

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3. Trial balance
❑ Errors not Affecting the Trial balance
An error may occur that does not cause the trial balance totals to be unequal. Such
an error may be discovered when preparing the trial balance or may be indicated
by an unusual account balance.

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4. Financial Analysis and interpretation: Horizontal Analysis

In horizontal analysis, the amount of each item on a current financial

statement is compared with the same item on an earlier statement.

• The increase or decrease in the amount of the item is computed together with
the percent of increase or decrease.
• When two statements are being compared, the earlier statement is used as the
base for computing the amount and the percent of change.

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4. Financial Analysis and interpretation: Horizontal Analysis

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4. Financial Analysis and interpretation: Horizontal Analysis

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 Financial Analysis and Interpretation

Objective: Use horizontal analysis to compare financial statements

from different periods.

Comparative Balance Sheet

December 31, 2003 and 2002
Increase (Decrease)
Assets 2003 2002 Amount Percent

Current assets $ 550,000 $ 533,000

Long-term investments 95,000 177,500

Plant assets (net) 444,500 470,000

Intangible assets 50,000 50,000

$1,139,500 $1,230,500
 Financial Analysis and Interpretation

Objective: Use horizontal analysis to compare financial statements

from different periods.

Comparative Balance Sheet

December 31, 2003 and 2002
Increase (Decrease)
Assets 2003 2002 Amount Percent
Current assets$ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Plant assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000Horizontal
— Analysis:
$1,139,500 $1,230,500 $ (91,000) (7.4%)
Current year (2003) $550,000
= 103.2%
Base year (2002) $533,000

Increase amount $17,000

= 3.2%
Base year (2002) $533,000
 Financial Analysis and Interpretation

Objective: Use horizontal analysis to compare financial statements

from different periods.
Comparative Income Statement
December 31, 2003 and 2002 Increase (Decrease)
2003 2002 Amount Percent
Sales $1,530,500 $1,234,000
Sales returns 32,500 34,000
Net sales $1,498,000 $1,200,000
Cost of goods sold 1,043,000 820,000
Gross profit $ 455,000 $ 380,000
 Financial Analysis and Interpretation

Objective: Use horizontal analysis to compare financial statements

from different periods.

Comparative Income Statement

December 31, 2003 and 2002 Increase (Decrease)
2003 2002 Amount Percent
Sales $1,530,500 $1,234,000 $296,500 24.0%
Sales returns 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000) 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Horizontal Analysis:
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Current year (2003) $1,498,000
= 124.8%
Base year (2002) $1,200,000

Increase amount $298,000

= 24.8%
Base year (2002) $1,200,000
 Key terms of chapter 2

Flashcard check-up

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Chapter 2 61