Chapter 02 – Accounting System and Financial Statements
Chapter Outline
Notes
d. Recompute each account balance in the ledger.
e. Verify that each journal entry is properly posted.
f. Verify that the original journal entry has equal debits and
credits.
2. If an error in a journal entry is discovered before the entry is
posted, it can be corrected in a manual system by drawing a
line through the incorrect information and writing in the
correct information.
3. If an error in a journal entry is not discovered until after it is
posted, a correcting entry that removes the amount from the
wrong account and records it to the correct account should be
journalized and posted.
C. Using a Trial Balance to Prepare Financial Statements
The statements prepared in this chapter are called unadjusted
statements because further account adjustments need to be made
(as described in chapter 3).
1. A balance sheet reports on an organization’s financial position
at a point in time. The income statement, statement of retained
earnings, and statement of cash flows report on financial
performance over a period of time.
2. A one-year, or annual, reporting period is known as the
nearest dollar, or even to a higher level.
Chapter 02 – Accounting System and Financial Statements
2-10
Chapter Outline
V. Global View
A. Analyzing and Recording Transactions – Both GAAP and IFRS
include broad and similar guidance for financial accounting but
these differences will fade as they work together toward a common
conceptual framework. All of the transactions in this chapter are
accounted for identically under these two systems.
B. Financial Statements – Both GAAP and IFRS prepare the same
four basic financial statements with some differences. Both require
balance sheets to separate current and noncurrent items. However,
GAAP balance sheets report current items first and IFRS balance
sheets present noncurrent items first (and equity before liabilities).
C. Accounting Controls and Assurance – Accounting systems
depend on control procedures that assure proper principles were
applied in processing accounting information. SOX legislation
strengthened U.S. control procedures. Global standards for control
are diverse which means that their application in different countries
can yield different outcomes depending on the quality of their
auditing standards and enforcement.
Notes
VI. Decision Analysis—Debt Ratio
A. A company that finances a relatively large portion of its assets
with liabilities has a high degree of financial leverage. Higher
financial leverage involves greater risk because liabilities must be
repaid and often require regular interest payments (equity
financing does not). The risk that a company might not be able to
meet such required payments is higher if it has more liabilities (is
more highly leveraged).
B. One way to assess the risk associated with a company’s use of
liabilities is to compute the debt ratio.
1. It is calculated as total liabilities divided by total assets.
2. It tells us how much (what percentage) of the assets are
financed by creditors (non-owners) or liability financing; the
higher the debt ratio, the more risk a company faces from its
financial leverage.
Chapter 02 – Accounting System and Financial Statements
2-11
VISUAL #2-1
THREE PARTS OF AN ACCOUNT
Left Side
Right Side
called
called
(2) DEBIT
(3) CREDIT
RULES FOR USING ACCOUNTS
Accounts are assigned balance sides (debit or credit).
To increase any account, use the balance side.
To decrease any account, use the side opposite the balance side.
FINDING ACCOUNT BALANCES
If total debits equals total credits, the account balance is zero.
If total debits are greater than total credits, the account has a
debit balance equal to the difference of the two totals.
If total credits are greater than total debits, the account has a
credit balance equal to the difference of the two totals.
Chapter 02 – Accounting System and Financial Statements
2-12
VISUAL #2-2
BALANCE SIDES
ALL ACCOUNTS ARE ASSIGNED BALANCE SIDES.
ASSETS
=
LIABILITIES + EQUITY
are on the left side of the
accounting equation,
therefore
they increase using the
debit or left side.
are on the right side of the
accounting equation,
therefore
they increase using the
credit or right side.
DEBIT BALANCE
CREDIT BALANCE
Asset Accounts
Liability Accounts
Equity Accounts
Debit
Credit
Debit
Credit
Debit
Credit
+ side
– side
– side
+ side
– side
+ side
Normal
Normal
Normal
Balance
Balance
Balance
Chapter 02 – Accounting System and Financial Statements
2-13
VISUAL #2-3
EQUITY ACCOUNTS
Common Stock
(increases equity, which is on the right
side of the accounting equation,
equity increases with credits)
Debit
Credit
– side
+ side
Normal
Balance
Dividends
(decreases equity,
equity decreases with debits)
Debit
Credit
+ side
– side
Normal
Balance
All Revenue Accounts
(increases equity,
equity increases with credits)
Debit
Credit
– side
+ side
Normal
Balance
All Expense Accounts
(decreases equity,
equity decreases with debits)
Debit
Credit
+ side
– side
Normal
Balance
Each time assets are
distributed to
stockholders,
the dividends account
balance increases.
As such, its normal
balance is a debit.
Each time
an expense
is incurred,
the expense account
balance increases.
As such, its normal
balance is a debit.
Chapter 02 – Accounting System and Financial Statements
2-14
VISUAL #2-4
USING ACCOUNTS – SUMMARY
Assets = Liabilities + Equity
Asset Accounts
Liability Accounts
Equity Accounts
Debit +
Credit +
Credit +
Balance
Balance
Balance
Equity Accounts
Common Stock
Dividends
Credit +
Debit +
Balance
Balance
Revenue Accounts
Expense Accounts
Credit +
Debit +
Balance
Balance
RULE REVIEW
Transaction analysis rules:
• Each transaction affects at least two accounts.
• Each transaction must have equal debits and credits.
General account use rules:
• To increase any account, use balance side.
• To decrease any account, use side opposite the
balance.
Chapter 02 – Accounting System and Financial Statements
2-15
Chapter 2 – Alternate Demonstration Problem #1
Wigor Inc. completed the following transactions during the year ended
December 31, 2013, its first year of operations:
a. Bill Wiggins personally invests $30,000 in the new business in
exchange for common stock and deposits the cash in a bank
account opened under the name of Wigor Inc.
b. Equipment for use in the business was purchased for $9,000.
Two-thirds of the price was paid in cash; the rest was due in a
year.
c. Service fees earned were $60,000; $6,000 of this was on credit.
d. Operating expenses incurred were $35,000; $4,000 was on credit.
e. Wigor Co. collected half the money owed to it.
f. Wigor Co. paid off $2,000 it owed.
g. Wiggins bought a car for $12,000 for his personal use, half paid
for now from his personal savings and half to be paid in a year.
Required:
1. Prepare journal entries for each of the events.
2. Prepare a trial balance at the end of the year for Wigor Inc.
Chapter 02 – Accounting System and Financial Statements
2-16
Solution: Chapter 2 – Alternate Demonstration Problem #1
1.
Dr.
Cr.
a.
Cash ………………………………………………..
30,000
Common Stock …………………………..
30,000
b.
Equipment ……………………………………….
9,000
Cash …………………………………………..
6,000
Accounts Payable ………………………
3,000
c.
Cash ………………………………………………..
54,000
Accounts Receivable ……………………….
6,000
Service Fee Earned …………………….
60,000
d.
Operating Expenses …………………………
35,000
Cash …………………………………………..
31,000
Accounts Payable ………………………
4,000
e.
Cash ………………………………………………..
3,000
Accounts Receivable ………………….
3,000
f.
Accounts Payable …………………………...
2,000
Cash …………………………………………..
2,000
g.
No entry because this is a personal
transactions
2.
WIGOR INC.
Trial Balance
December 31, 2013
Dr.
Cr.
Cash ………………………………………………………………….
$48,000
Accounts receivable ………………………………………….
3,000
Equipment …………………………..…………………………….
9,000
Accounts payable ………………………………………………
$ 5,000
Common Stock ………………………………………………….
30,000
Service fees earned ……………………………………………
60,000
Operating expenses …………………………………………..
35,000
______
Totals …………………………..……………………………………
$95,000
$95,000