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.