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Chapter 3
Recording Transactions
Learning Objectives
After studying this chapter, you should be able to:
Use double-entry accounting.
Analyze and journalize transactions.
Post journal entries to the ledgers.
Prepare and use a trial balance.
Close revenue and expense accounts and update retained income.
Correct erroneous journal entries and describe how errors affect accounts.
Use T-accounts to analyze accounting relationships.
Explain how computers have transformed processing of accounting data.
The Double-Entry
Accounting System
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.
Double entry accounting system is the method usually followed for recording transactions, whereby every
transaction affects at least two accounts
The Double-Entry
Accounting System
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.
The balance sheet equation can be used for this analysis, but with so many transactions, this is not
realistic.
In practice, accountants use ledgers.
Ledger Accounts
Ledger contains the record for a group of related accounts kept current in a
systematic manner
Think of a ledger as a book with one page for each account.
The ledger is a companys books.
General ledger - the collection of accounts that accumulates the
amounts reported in the major
financial statements
Ledger
Ledger Accounts 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 Right Side
Ledger Accounts
In practice, accounts are created as per the need
The process of creating a new account is called Opening the Account
Each T-Account summarizes the changes in the particular accounts
T-Accounts show only the Amounts and NOT the transaction description
Ledger Accounts
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
Ledger Accounts
T-accounts and the balance sheet equation:
Assets = Liabilities + Owners Equity
Assets Liabilities
Owners Equity
Increases Decreases Decreases Increases
Decreases Increases
Ledger Accounts
Each transaction generates a right side entry in one T- account and a left side
entry in another T- account, of the same
amount if there are only two accounts
affected.
Compound entries effect more than 2 T-accounts with different amounts.
Debits and Credits
Debit (dr.) Denotes an entry on the left side of an account
Credit (cr.) Denotes an entry on the right side of an account
Remember:
Debit is always the left side!
Credit is always the right side!
The Recording Process
The sequence of steps in recording transactions:
Transactions Source
Documentation
Journal
Financial
Statements
Trial
Balance Ledger
The Recording Process
Step 1.
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.
The Recording Process
Step- 2
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 entitys life.
The Recording Process
Step-3
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.
The Recording Process
Step-4
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
The Recording Process
Step-5
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 financial statements at
various other intervals to
meet the needs of their users.
December 2002
Journalizing Transactions
Journalizing - the process of entering transactions into the journal
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.
Journalizing Transactions
The conventional form for journal entries includes the following:
The date and identification number of the entry
The accounts affected and 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
Journalizing Transactions
A journal entry for the following transaction will look like this:
Purchased merchandise inventory for cash Rs.1,50,000 on Jan 1, 2002
Journal entry
2002 dr. cr.
Jan 2 Inventory 1,50,000
Cash 1,50,000
Journalizing Transactions
The conventional form for recording in the general journal:
Entry Post. Date No. Accounts and Explanations Ref Debit Credit
2001
12/31 1 Cash 100 400,000
Paid-in capital 300 400,000
(Capital Stock issued)
12/31 2 Cash 100 100,000
Note payable 202 100,000
2002 (Borrowed at 9% interest on a 1 yr note)
1/2 3 Merchandise inventory 130 150,000
Cash 100 150,000
(Acquired inventory for cash)
Chart of Accounts
Chart of accounts - a numbered or coded list of all account titles used to record
transactions
Account Account Account Account Number Title Number Title
100 Cash 202 Notes payable
120 Accounts receivable 203 Accounts payable
130 Merchandise inventory 300 Paid-in capital
140 Prepaid rent 400 Retained income
170 Store equipment 500 Sales revenue
170A Accumulated 600 Cost of goods sold
depreciation 601 Rent expense
602 Depreciation expense
Posting Transactions
to the Ledger
Posting is the 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.
Strictly a mechanical process and hence generally done electronically
Posting Transactions
to the Ledger
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.
Analyzing, Journalizing, and
Posting Transactions
Types 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
Remember: whether the entry is simple or compound, the debits (left side) and credits (right
side) must always equal.
Analyzing, Journalizing, and Posting
Transactions Jan 3 The company buys bicycles for Rs.10,000 from a
manufacturer. Manufacturer requires Rs.4,000 by Jan 10 and
balance in 30 days
Jan 4 Co. buys store equipment for a total of Rs.15,000. A cash
down payment of Rs.4,000 is made. Remaining must be paid in
60 days
Jan 5 Co. sells a store equipment to another business. Its selling
price is Rs.1,000 which is exactly equal to its cost. The buyer
agrees to pay within 30 days
Jan 6 Co. returns inventory worth Rs.800 which had been acquired
on credit on Jan 3 to the manufacturer.
Jan 10 Co pays to the manufacturer Rs.4,000 for Jan 3 transaction
Jan 12 Co. collects Rs.700 of Rs.1,000 for the store equipment it had
sold on Jan 5
Jan 12 The owner remodels his home Rs.35,000 paying by cheque
from his personal account
Revenue and Expense Transactions
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
By accumulating revenues and expenses separately, a more meaningful income
statement can be easily prepared.
Revenue and Expense Transactions
Revenue and expense accounts are a part of Retained Income.
They are LITTLE STOCKHOLDERS ACCOUNT
Retained Income
Expense Revenue
Decrease Increase
Debit
Increase
Credit
Increase
Revenue and Expense Transactions
Summary 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.
Revenue and Expense Transactions
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.
Prepaid Expense and Depreciation
Transactions
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.
With depreciation, a new account,
Accumulated Depreciation, is introduced. the cumulative sum of all depreciation recognized
since the date of acquisition of a particular asset
Prepaid Expense and Depreciation
Transactions
Contra account :
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.
Book value - the balance of an account, net of any contra accounts (net book value, carrying amount, or
carrying value)
= Acquisition Cost - Accumulated Depreciation.
Accumulated Depreciation
Why use accumulated depreciation? Why not just reduce the asset account
as it expires?
Transactions in the
Journal and Ledger
Some details to remember:
Do not use Rupee 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.
Trial Balance
Once all transactions have been posted to the ledger, a trial balance is prepared.
Trial balance - a list of all of the accounts with their balances
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
Preparing the Trial Balance
The trial balance is usually prepared with the balance sheet accounts first, followed by the income statement accounts.
Order is : Current Assets
Fixed Assets
Current Liabilities
Long term Liabilities
Paid in Capital
Retained Incomes
Sales Revenue
COGS
Expenses
TOTAL
Preparing the Trial Balance
An example of a short trial balance:
Account Number Account Title Debit Credit
100 Cash $350,000
130 Merchandise inventory 150,000
202 Note payable $100,000
300 Paid-in capital 400,000
500,000 5,00,000 ================== = ==================
Deriving Financial Statements from
the Trial Balance
The trial balance is the starting point for the preparation of the balance sheet and the income
statement.
The income statement accounts are summarized later in a single account called Net Income, which
becomes part of Retained Income in the balance
sheet.
ABC Company,
Trial Balance January 30,2008
Debits Credits
Cash 336700
A/R 160300
Inventory 59200
Prepaid Rent 4000
Machinery 14000
Accumulated Depreciation, Machinery 100
Loan 100000
A/P 16200
Paid in Capital 400000
Retained Income 0
Sales Revenue 160000
COGS 100000
Salary Expense 2000
Depreciation expense 100
TOTAL 676300 676300
Disadvantage of the Trial Balance
Note that a trial balance may balance even when errors were made in recording or posting.
A transaction may be recorded in different amounts
A transaction may be recorded in a wrong account.
In both situations, the total debits will still equal total credits on the trial balance.
Dr. = Cr.
Closing the Accounts
Once the financial statements are prepared, the ledger accounts must be prepared to record the next periods transactions. This process is called closing the books.
The balances in all temporary stockholders
equity accounts are transferred to a Retained Income Account via a temporary Income Summary account.
The revenue and expense accounts are reset to zero and the current net income is transferred to Retained Income.
The Closing Process
Step 1:
The revenue accounts are closed to Income Summary
Step 2:
The expense accounts are closed to Income Summary
Step 3:
The amount of Net Income (revenues - expenses) is
then transferred from Income Summary to Retained
Income.
Capital Vs Revenue
The items of expenses and income, are termed as Revenue by accountants- they are short lived and closed by transferring to Income Summary Account
The credit and debit balances in Trial Balance which remain unclosed (not transferred to Income Summary Account) are called Capital- They survive and move to the next year as opening balances
- All Asset accounts, Liability accounts, Paid in Capital and Retained Earnings account are called Capital
Effects of Errors
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.
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.
Effects of Errors
A correcting entry is recorded in the General Journal and posted to the ledger exactly as regular entries are.
Focus is on the FINAL BALANCES of accounts and not on the flow of entries, because ultimately it is the FINAL BALANCES that are used for preparing the Financial Statements
Correcting Entry
Equipment account erroneously debited for a repair expense paid on 31st Jan,
2009. The error is detected on 1st Feb..
What is the erroneous entry?
What should have been the correct entry?
What should be the correcting entry to be passed on 1st Feb?
Types of Error
Errors of Commission- When a wrong account is journalized (debited or
credited) or a wrong amount is entered.
Errors of Principles- An error due to non-compliance of rules of
accounting
Error of Omission- The complete omission of a transaction due to
neglect of recklessness
Effect of Errors
Some errors may be Temporary while some errors persist till corrected.
1. Temporary Errors
- Some errors, which remain undetected by accountants, can effect a variety of items including revenue and expenses for a given period.
- However they get automatically corrected in the next period- they have counterbalance effect in two accounting periods which nullifies their effect
Effect of Errors
E.g.- Rent paid in advance, Rs.100 on 1st December 2007 for the month of January
2008, wrongly recorded as Rent Expense
Effect in 1st year (2007) Effect in 2nd year(2008)
-Rent Expense will be
overstated by 100
-Pre tax Income will be
understated 100
-Assets understated by 100
-Rent expense understated
by 100
-Pre tax Income overstated
by 100
-No effect
Incorrect Entry
On 1st Dec 2007
Correct Entry
On 1st Dec 2007
Correct Entry
On 31st Jan 2008
Rent Exp100
Cash 100
Prepaid Rent..
Cash..
Rent Exp
Prepaid Rent.
2. Errors that are not
counterbalanced
Errors that are not counterbalanced will
keep the balance sheet incorrect
until correcting entries are made.
e.g.: Overlooking a depreciation expense by Rs.500 in
year 1
Effect:
Year 1: Overstated Pretax income, Assets and Retained
Income
Subsequent Years: Overstated Asset and RI
Incomplete Records
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.
Incomplete Records
You need to help a store owner in calculating the sales for the year 2008 as he has lost the
records. Following information has been
provided by him:
List of customers who owe money-
- On December 31st, 2007= Rs.14000
- On December 31st, 2008= Rs.28,000
- Cash receipts from customers during 2008
=Rs.4,00,000 (All sales being on credit)
Data Processing and Computers
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.
Data Processing and Computers
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.