Chapter 02 – Accounting System and Financial Statements
2-1
Chapter 02
Accounting System and Financial Statements
Student Learning Objectives and Related Assignment Materials*
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises
Problems
(A &B set)**
Beyond the
Numbers
Conceptual objectives:
C1. Explain the steps in processing
transactions and the role of
source documents.
3
2-1
2-1
2-5
EC, CIP,
TIA, HTR
C2. Describe an account and its use
in recording transactions.
1, 4, 14, 16
2-2
2-2
CIP, TIA
C3. Describe a ledger and a chart of
accounts.
6
2-3
2-3, 2-13
2-1, 2-2, 2-3,
2-4, 2-5, 2-6
C4. Define debits and credits and
explain double-entry
accounting.
5, 7
2-4, 2-5, 2-
10
2-4
2-1, 2-2, 2-3
TIA
Analytical objectives:
A1. Analyze the impact of
transactions on accounts and
financial statements.
2
2-6
2-5, 2-6, 2-9,
2-11, 2-12,
2-16, 2-18,
2-20, 2-21
2-1, 2-2, 2-3,
2-4, 2-5, 2-6
RIA, CA,
CIP, TTN,
TIA, ED
A2. Compute the debt ratio and
describe its use in analyzing
company performance.
2-22
2-4
RIA, CA,
ED, GD
Procedural objectives:
P1. Record transactions in a journal
and post entries to a ledger.
2-7
2-7, 2-11,
2-12, 2-19
2-1, 2-2, 2-3,
2-4, 2-6
P2. Prepare and explain the use of a
trial balance.
8, 9
2-8
2-8, 2-10,
2-20, 2-21
2-1, 2-2, 2-3,
2-4, 2-5, 2-6
P3. Prepare financial statements
from business transactions.
10, 11, 12,
13, 15, 16,
17, 18, 19
2-9
2-13, 2-14,
2-15, 2-17,
2-23
2-4
CIP, ED
Notes appear on next page.
Chapter 02 – Accounting System and Financial Statements
* Assignment materials that can be completed by students using:
Chapter 02 – Accounting System and Financial Statements
2-3
Chapter Outline
Notes
I. Using Financial Statements
Financial statement analysis is used by both internal and external users
of accounting, with a common goal to evaluate company performance
and financial condition. When assessing company results we use the
following standards: intracompany, intercompany, industry, and
guidelines for comparisons.
A. Using Ratios to Analyze Financial Statements. Ratio analysis is
the most widely used tool of financial analysis. A ratio expresses a
mathematical relation between two quantities and can uncover a
condition or trend.
1 Liquidity (and Efficiency)-ability to meet short-term
obligations and generate revenues. Liquidity is often
assessed by the current ratio = current assets/current
liabilities.
2 Solvency –ability to generate future revenues and
meet long-term obligations. It is often assessed by the debt
ratio = total liabilities/total assets.
3 Profitability — ability to provide financial rewards
sufficient to attract and retain financing. It is often assed by
the profit margin ratio = net income/net sales.
4 Market Prospects—ability to generate positive
market expectations. Often measured with the price-to–
earnings ratio = price per share/earnings per share
B. Summarizing Ratios
II Analyzing and Reporting Accounts
The accounting process identifies business transactions and events,
analyzes and records their effects, and summarizes and presents
information in reports and financial statements. The steps in the
accounting process that focus on analyzing and recording transactions
and events are: (1) record relevant transactions and events in a journal,
(2) post journal information to ledger accounts, and (3) prepare and
analyze the trial balance. Accounting records are informally referred to
as the accounting books, or simply the books.
A. Source documents identify and describe transactions and events.
Source documents are sources of accounting information and can
be either hard copy or electronic. Examples are sales tickets,
checks, purchase orders, bills from suppliers, employee earnings
records, and bank statements. Source documents provide objective
and reliable evidence about transactions and events.
B. The Account and Its Analysis.
1. 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 a company.
2. Accounts are arranged in three basic categories based on the
accounting equation. A separate account is kept for each of
the following:
Chapter 02 – Accounting System and Financial Statements
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Chapter Outline
Notes
a. Asset Accounts—resources owned or controlled by a
company that have expected future benefits; examples
include Cash, Accounts Receivable, Note Receivable,
Prepaid Accounts, Supplies, Equipment, Buildings, and
Land.
b. Liability Accounts—claims by creditors against assets;
obligations to transfer assets or provide products or
services to others; examples include Accounts Payable,
Note Payable, Unearned Revenue, and Accrued
Liabilities. Creditors are individuals or organizations that
have rights to receive payments from a company.
c. Equity Accounts—owner’s residual interest in the assets
of the business after deducting liabilities; examples
include Common Stock, Dividends, Revenues, and
Expenses.
III. Analyzing and Processing Transactions
A. Ledger and Chart of Accounts
1. A ledger (or general ledger) is the collection of all the
accounts a company uses.
2. The chart of accounts is a list of all ledger accounts with their
identification numbers.
B. Debits and Credits
1. A T-account represents a ledger account and is used to
understand the effects of one or more transactions.
2. The left side of an account is called the debit side. A debit is
an entry on the left side of an account.
3. The right side of an account is called the credit side. A credit
is an entry on the right side of an account.
4. Whether a debit or a credit is an increase or decrease depends
on the account.
5. In an account where a debit is an increase, the credit is a
decrease. In an account where a credit is an increase, the debit
is a decrease.
6. The account balance is the difference between the total debits
and the total credits recorded in an account.
C. Double-Entry Accounting
1. For each transaction, at least two accounts are involved. The
total amount that is debited to accounts must equal the total
amount credited to accounts for each transaction. The sum of
debit account balances in the ledger must equal the sum of
credit account balances.
Chapter Outline
Chapter 02 – Accounting System and Financial Statements
2. Assets are on the left side of the equation; therefore, the left,
or debit, side is the normal balance side for assets.
3. Liabilities and equities are on the right side; therefore, the
right, or credit, side is the normal balance side for liabilities
and equity.
4. Equity increases from revenues and stock issuances and it
decreases from expenses and dividends. Increases (credits) to
common stock and revenues increase equity; increases
(debits) to dividends and expenses decrease equity.
5. The normal balance of each account (assets, liability, common
stock, dividends, revenue, or expense) refers to the left or right
(debit or credit) side where increases are recorded.
D. Journalizing and Posting Transactions
1. A journal gives a complete record of each transaction in one
place; it shows the debits and credits for each transaction. The
process of recording each transaction in a journal is called
journalizing. The process of transferring journal entry
information to the ledger is called posting.
2. The general journal can be used to record any type of
transaction. Steps for recording entries in a general journal
include:
a. Date the transaction; enter the year at the top of the first
column and the month and day on the first line of each
journal entry.
b. Enter titles of accounts debited (account titles are taken
from the chart of accounts and aligned with the left margin
of the column), and then enter amounts in the Debit
column on the same line.
c. Enter titles of accounts credited (account titles are taken
from the chart of accounts and indented from the left
margin of the column to distinguish them from debited
accounts), and then enter amounts in the Credit column on
the same line.
d. Enter a brief explanation of the transaction on the line
below the entry.
3. A blank line is left between each journal entry for clarity.
4. When a transaction is first recorded, the posting reference
(PR) column is left blank (in a manual system); later, when
posting entries to the ledger, the identification numbers of the
individual ledger accounts are entered in the PR column.
5. Balance Column Account. T-accounts are simple and direct
means to show how the accounting process works; however,
actual accounting systems need more structure and therefore
use balance column accounts. The balance column account
format is similar to a T-account in having columns for debits
and credits; it is different in including date and explanation
columns.
Chapter 02 – Accounting System and Financial Statements
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Chapter Outline
Notes
6. The heading of the Balance column does not show whether it
is a debit or credit balance; instead, an account is assumed to
have a normal balance (that is, the side where increases are
recorded). Unusual events can temporarily give an account an
abnormal balance (that is, the side where decreases are
recorded).
7. Posting Journal Entries. To ensure the ledger is up-to–date,
entries are posted as soon as possible using the following
steps:
a. First, identify the ledger account that is debited in the
entry; then, in the ledger, enter the date, the journal and
page in its PR column, the debit amount, and the new
balance of the ledger accounts.
b. Second, enter the ledger account number in the PR column
of the journal.
c. Repeat the first two steps for credit entries and amounts.
E. Analyzing Transactions – An Illustration
The illustrations below follow a four step process: Review the
transaction and source documents. Analyze the transaction in
terms of its effect on the accounting equation. Double-entry
accounting is used to record the transaction in journal entry form,
and the entry is posted to the general ledger account. (The
following abbreviations are used for the financial statements: IS
for income statement, BLS for balance sheet, SCF for statement of
cash flows, and SRE for statement of retained earning.) The first
eleven transactions are from Chapter 1; five additional transactions
are included.
Transaction 1: Investment by owner
Analysis:
+ Assets (Cash) = + Equity (Common Stock)
Double entry:
Debit Cash and credit Common Stock
Statements affected:
BLS and SCF
Transaction 2: Purchase supplies for cash
Analysis:
+Assets (Supplies) = – Assets (Cash)
Double entry:
Debit Supplies and credit Cash
Statements affected:
BLS and SCF
Transaction 3: Purchase equipment for cash
Analysis:
+ Assets (Equipment) = – Assets (Cash)
Double entry:
Debit Equipment and credit Cash
Statements affected:
BLS and SCF
Chapter 02 – Accounting System and Financial Statements
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Chapter Outline
Notes
Transaction 4: Purchase supplies on credit
Analysis:
+Assets (Supplies) = + Liability (Account Payable)
Double entry:
Debit Supplies and credit Accounts Payable
Statements affected:
BLS
Transaction 5: Provide services for cash
Analysis:
+ Assets (Cash) = + Equity (Revenues)
Double entry:
Debit Cash and credit Revenue (type of revenue would be
identified in account name)
Statements affected:
BLS, IS, SCF, and SRE
Transactions 6 and 7: Payment of expenses in cash
Analysis:
– Assets (Cash) = – Equity (Expenses)
Double entry:
Debit Expenses (type of expense would be identified in account
name) and credit Cash
Statements affected:
BLS, IS, SCF, and SRE
Transaction 8: Provide consulting and rental services on credit
Analysis:
+ Assets (Accts Receivable) = + Equity (Revenues)
Double entry:
Debit Accounts Receivable and credit Revenue (type of revenue
would be identified in account name)
Statements affected:
BLS, IS, SCF, and SRE
Transaction 9: Receipt of cash on account
Analysis:
+ Assets (Cash) = – Assets (Accounts Receivable)
Double entry:
Debit Cash and credit Accounts Receivable
Statements affected:
BLS and SCF
Transaction 10: Partial payment of accounts payable
Analysis:
– Assets (Cash) = – Liability (Accounts Payable)
Double entry:
Debit Accounts Payable and credit Cash
Statements affected:
BLS and SCF
Transaction 11: Payment of cash dividend
Analysis:
– Assets (Cash) = – Equity (Dividends)
Double entry:
Debit Dividends and credit Cash
Statements affected:
BLS, SCF, and SRE
Chapter Outline
Notes
Transaction 12: Receipt of cash for future services
Chapter 02 – Accounting System and Financial Statements
2-8
Analysis:
+ Assets (Cash) = + Liabilities (Unearned Revenue)
Double entry:
Debit Cash and credit Unearned Revenue (type of unearned
revenue is often identified in account name)
Statements affected:
BLS and SCF
Transaction 13: Pay cash for future insurance coverage
Analysis:
– Assets (Cash) = + Assets (Prepaid Insurance)
Double entry:
Debit Prepaid Insurance and credit Cash
Statements affected:
BLS and SCF
Transaction 14: Purchase supplies for cash
Analysis:
+ Assets (Supplies) = – Assets (Cash)
Double entry:
Debit Supplies and credit Cash
Statements affected:
BLS and SCF
Transactions 15 and 16: Payment of expenses in cash
Analysis:
– Assets (Cash) = – Equity (Expenses)
Double entry:
Debit Expense (type of expense would be identified in account
name) and credit Cash
Statements affected:
BLS, IS, SCR, and SRE
IV. Trial Balance
A. Preparing a Trial Balance
1. A trial balance is a list of accounts and their balances at a
point in time used to confirm that the sum of debit account
balances equals the sum of credit account balances.
2. The three steps to preparing a trial balance are as follows:
a. List each account and its amount (from the ledger),
b. Compute the total debit balances and the total credit
balances, and
c. Verify (prove) total debit balances equal total credit
balances.
B. Searching for and Correcting Errors
1. If a trial balance does not balance (the columns are not equal),
the error(s) must be found and corrected. Find the errors by
checking the following:
a. Verify that the trial balance columns are correctly added.
b. Verify that the account balances are accurately entered
from the ledger.
c. See whether a debit (or credit) balance is mistakenly listed
in the trial balance as a credit (or debit).