3 1 Chapter 3 Recording Transactions 2002 Prentice

3 -1 Chapter 3 Recording Transactions © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 -2 Learning Objectives After studying this chapter, you should be able to: u Use double-entry accounting. u Analyze and journalize transactions. u Post journal entries to the ledgers. u Prepare and use a trial balance. u Close revenue and expense accounts and update retained income. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 -3 Learning Objectives After studying this chapter, you should be able to: u Correct erroneous journal entries and describe how errors affect accounts. u Use T-accounts to analyze accounting relationships. u Explain how computers have transformed processing of accounting data. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

The Double-Entry Accounting System 3 -4 u Some businesses enter into thousands of transactions daily or even hourly. • Accountants must carefully keep track of and record these transactions in a systematic manner. u Accountants use a double-entry accounting system in which at least two accounts are always affected by each transaction. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

The Double-Entry Accounting System 3 -5 u Each transaction must still be analyzed to determine which accounts are involved, whether the accounts increase or decrease, and how much the balance will change. u The balance sheet equation can be used for this analysis, but with so many transactions, this is not realistic. • In practice, accountants use ledgers. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 -6 Ledger Accounts u Ledger - a group of related accounts kept current in a systematic manner • Think of a ledger as a book with page for each account. • The ledger is a company’s “books. ” one Ledger u General ledger - the collection of accounts that accumulates the amounts reported in the major financial statements © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 -7 Ledger Accounts u. A simplified version of a ledger account is called the T-account. • They allow us to capture the essence of the accounting process without having to worry about too many details. • The account is divided into two sides for recording increases and decreases in the accounts. Account Title Left Side © 2002 Prentice Hall Business Publishing Right Side Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 -8 Ledger Accounts u Balance - difference between total left-side amounts and total right-side amounts at any particular time • Assets have left-side balances. – Increased by entries to the left side – Decreased by entries to the right side • Liabilities and Owners’ Equity have right-side balances. – Decreased by entries to the left side – Increased by entries to the right side © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 -9 Ledger Accounts u T-accounts and the balance sheet equation: Assets = Liabilities + Owners’ Equity Assets Increases Decreases Liabilities Decreases Increases Owners’ Equity Decreases © 2002 Prentice Hall Business Publishing Increases Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 10 Debits and Credits u Debit (dr. ) - an entry or balance on the left side of an account u Credit (cr. ) - an entry or balance on the right side of an account u Remember: • Debit is always the left side! • Credit is always the right side! © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 11 The Recording Process u The sequence of steps in recording transactions: Transactions Financial Statements © 2002 Prentice Hall Business Publishing Documentation Journal Trial Balance Ledger Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 12 The Recording Process u The process starts with source documents, which are the supporting original records of any transaction. • Examples are sales slips or invoices, check stubs, purchase orders, receiving reports, and cash receipt slips. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 13 The Recording Process u In the second step, an analysis of the transaction is placed in the book of original entry, which is a chronological record of how the transactions affect the balances of applicable accounts. • The most common example is the general journal - a diary of all events (transactions) in an entity’s life. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 14 The Recording Process u In the third step, transactions are entered into the ledger. • Remember that a transaction is not entered in just one place; it must be entered in each account that it affects. • Depending on the nature of the organization, analysis of the transactions could occur continuously or periodically. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 15 The Recording Process u The fourth step includes the preparation of the trial balance, which is a simple listing of all accounts in the general ledger with their balances. • Aids in verifying accuracy and in preparing the financial statements • Prepared periodically as necessary © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 16 The Recording Process u In the final step, the financial statements are prepared. • Financial statements are prepared each quarter of the year for publicly traded companies. • Other companies prepare December 2002 financial statements at various other intervals to meet the needs of their users. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 17 Journalizing Transactions u Journalizing - the process of entering transactions into the journal u Journal entry - an analysis of the effects of a transaction on the accounts, usually accompanied by an explanation of the transaction • This analysis identifies the accounts to be debited and credited. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 18 Journalizing Transactions u The conventional form for journal entries includes the following: • The date and identification number of the entry • The accounts affected an explanation of the transaction • The posting reference, which is the number assigned to each account affected by the transaction • The amounts that the accounts are to be debited and credited © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 19 Journalizing Transactions u The conventional form for recording in the general journal: Date 2001 12/31 2002 1/2 Entry No. 1 2 3 Accounts and Explanations Post. Ref Debit Credit Cash Paid-in capital 100 300 400, 000 Cash Note payable 100 202 100, 000 Merchandise inventory Cash 130 100 150, 000 © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition 400, 000 150, 000 Horngren, Sundem, and Elliott

3 - 20 Chart of Accounts u Chart of accounts - a numbered or coded list of all account titles used to record transactions Account Number 100 120 130 140 170 A Account Title Cash Accounts receivable Merchandise inventory Prepaid rent Store equipment Accumulated depreciation © 2002 Prentice Hall Business Publishing Account Number 203 300 400 Account Title 202 Notes payable Accounts payable Paid-in capital Retained income 500 Sales revenue 600 Cost of goods sold 601 Rent expense 602 Depreciation expense Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Posting Transactions to the Ledger 3 - 21 u Posting - transferring of amounts from the journal to the appropriate accounts in the ledger • Dates, explanations, and journal references are provided in detail on paper formatted with special columns. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Posting Transactions to the Ledger 3 - 22 u Cross-referencing - the process of numbering or otherwise specifically identifying each journal entry and each posting • Transactions are often posted to several different accounts, but cross-referencing allows users to find all components of a transaction in the ledger no matter where they start. • Cross-referencing also allows auditors to find and correct errors. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 23 Running Balance Column u Ledgers do not always look like T-accounts. u One format is much like the check register in your checkbook and provides columns for: • • • The date An explanation A journal reference Debits Credits The balance © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 24 Running Balance Column u The running balance provides a status report for an account at a glance at any given point in time. CASH Date Explanation 2001 12/31 2002 1/2 © 2002 Prentice Hall Business Publishing Account No. 100 Journal Ref. Debit 1 2 400, 000 100, 000 3 Introduction to Financial Accounting, 8 th Edition Credit Balance 400, 000 500, 000 150, 000 350, 000 Horngren, Sundem, and Elliott

Analyzing, Journalizing, and Posting Transactions u Types 3 - 25 of journal entries: • Simple entry - an entry for a transaction that affects only two accounts • Compound entry - an entry for a transaction that affects more than two accounts u Remember: whether the entry is simple or compound, the debits (left side) and credits (right side) must always equal. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Revenue and Expense Transactions 3 - 26 u Retained Income is merely accumulated revenues less expenses, but we cannot just increase or decrease the Retained Income account directly. • This would make preparing the income statement very difficult u By accumulating revenues and expenses separately, a more meaningful income statement can be easily prepared. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Revenue and Expense Transactions 3 - 27 u Revenue and expense accounts are a part of Retained Income Decrease Expense Increase Revenue Debit Credit Increase © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Revenue and Expense Transactions u Summary 3 - 28 of revenue and expense transactions: • A credit to a revenue increases the revenue and increases Retained Income. • A debit to a revenue decreases the revenue and decreases Retained Income. • A credit to an expense decreases the expense and increases Retained Income. • A debit to an expense increases the expense and decreases Retained Income. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Revenue and Expense Transactions 3 - 29 u Keeping revenues and expenses in separate accounts makes the preparation of the income statement easier. • The income statement provides a detailed explanation of how operations caused the balance of Retained Income shown on the balance sheet to change from the beginning of the year to the end of the year. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Prepaid Expense and Depreciation Transactions 3 - 30 u Prepaid expenses relate to assets having useful lives that will expire sometime in the future. • The expiration, or using up, of those assets is an expense. u With depreciation, a new account, Accumulated Depreciation, is introduced. • Accumulated depreciation - the cumulative sum of all depreciation recognized since the date of acquisition of a particular asset © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Prepaid Expense and Depreciation Transactions 3 - 31 u An accounts such as Accumulated Depreciation is called a contra account, which is a separate but related account that offsets or is a deduction from a companion account. u Book value - the balance of an account, net of any contra accounts (a. k. a net book value, carrying amount, or carrying value) • The book value of an asset is its acquisition cost minus accumulated depreciation. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

A Note on Accumulated Depreciation 3 - 32 u Why use accumulated depreciation? Why not just reduce the asset account as it expires? • Accountants want the acquisition cost to remain on the books, so the asset must be “reduced” in some manner. • Also, the acquisition cost of the asset is a reliable and objective number, whereas accumulated depreciation is an estimate of the allocation of the cost of that asset over the period that it benefits. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Transactions in the Journal and Ledger u Some 3 - 33 details to remember: • Do not use dollar signs in either the journal or the ledger. • Do not use negative numbers. The effect on the account is conveyed by the side (debit or credit) on which the number appears. • For ledgers that do not have a running balance (such as T-accounts), the balances may be updated from time to time. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 34 Preparing the Trial Balance u Once all transactions have been posted to the ledger, a trial balance is prepared. u Trial balance - a list of all of the accounts with their balances • It is prepared as a test or check before continuing the recording process. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 35 Preparing the Trial Balance u The purposes of the trial balance: • To help check on accuracy of posting by proving whether the total debits equal the total credits • To establish a convenient summary of balances in all accounts for the preparation of formal financial statements © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 36 Preparing the Trial Balance u The trial balance is usually prepared with the balance sheet accounts first, followed by the income statement accounts. u An Account Number 100 130 202 300 example of a short trial balance: Account Title Cash Merchandise inventory Note payable Paid-in capital © 2002 Prentice Hall Business Publishing Debit Credit $350, 000 150, 000 $500, 000 $100, 000 400, 000 $500, 000 =================== Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Deriving Financial Statements from the Trial Balance 3 - 37 u The trial balance is the starting point for the preparation of the balance sheet and the income statement. • The income statement accounts are summarized in a single account called Net Income, which becomes part of Retained Income in the balance sheet. • The trial balance shows the beginning balance in Retained Income because no changes have actually been made to the account during the year. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Deriving Financial Statements from the Trial Balance 3 - 38 u Note that a trial balance may balance even when errors were made in recording or posting. • A transaction may be recorded as different amounts in two different accounts. • A transaction may be recorded in a wrong account. u In both situations, the total debits will still equal total credits on the trial balance. Dr. = Cr. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 39 Closing the Accounts u Once the financial statements are prepared, the ledger accounts must be prepared to record the next period’s transactions. This process is called closing the books. • The balances in all “temporary” stockholders’ equity accounts are transferred to a “permanent” stockholders’ equity account. • The revenue and expense accounts are “reset” to zero and the current net income is transferred to Retained Income. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 40 Closing the Accounts u The Closing Process: • The revenue accounts are closed to Income Summary in the first entry. • The expense accounts are closed to Income Summary in the second entry. • The amount of Net Income (revenues - expenses) is then transferred from Income Summary to Retained Income. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 41 Effects of Errors u When a journal entry contains an error, it can be erased or crossed out only if the error is detected before the entry is posted to the ledgers. u If the error is detected after posting, a correcting entry must be made. • The correcting entry counteracts the incorrect entry and assures that the correct account is debited or credited for the proper amount. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Some Errors Are Counterbalanced 3 - 42 u Some errors are counterbalanced by offsetting errors in the next accounting period. • Errors misstate net income in both periods, but by the end of the second period, the errors offset each other. • Errors misstate the balance sheet of the first year, not the second year because the errors offset each other. u Errors that are not counterbalanced will keep the balance sheet incorrect until correcting entries are made. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 43 Incomplete Records u Accountants must sometimes “fill in the blanks” when accounting records are lost, stolen, or destroyed. • T-accounts can help to recreate and calculate unknown amounts. – The accountant must understand the account and the amounts that flow through it in order to determine unknown amounts. • This process can become extremely complicated when many accounts are used. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 44 Data Processing and Computers u Data processing - the procedures used to record, analyze, store, and report on chosen activities • An accounting system is one type of data processing system. • Accounting systems are now likely to be computerized, but regardless of format, information still must be entered. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 45 Data Processing and Computers u Advantages to computerized systems: • Managers can get daily financial reports. • Employees can enter transactions into a terminal, such as a cash register, and the computer will perform many tasks (update inventory, perform credit checks, and prepare monthly statements for mailing to customers). • The computer can automatically record each transaction as soon as it happens thereby reducing much of the paperwork and data processing costs. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

3 - 46 Introduction to Financial Accounting 8 th Edition Power. Point Presentation Developed by: Eddie Metrejean, MTAX, CPA University of Mississippi Images provided by New Vision Technology 1 -800 -387 -0732 nvtech. com © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott