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Chapter 2
Analyzing and Recording Business Transactions
Learning Objectives
1. Explain how the concepts of recognition, valuation, and classication apply to business
transactions.
2. Explain the double-entry system and the usefulness of T accounts in analyzing business
transactions.
3. Demonstrate how the double-entry system is applied to common business transactions
4. Prepare a trail balance and describe its value and limitations.
5. Record transactions in the general journal and post transactions to the ledger.
6. Explain why ethical nancial reporting depends on proper recording of business
transactions.
7. Show how the timing of transactions a-ects cash .ows and liquidity.
Section 1: Concepts
Concepts
Recognition
Valuation
Classication
Lecture Outline
0. Three measurement issues must be resolved before a business transaction is recorded.
0. Recognition issue—When should the transaction be recorded?
0. Valuation issue—What dollar amount should be recorded?
0. Classication issue—Which accounts are a-ected?
0. A sale is recognized when title passes to the buyer (recognition point).
0. Transactions should be recorded at their original cost (historical cost).
A0. The fair value is the exchange price, which results from an agreement between the
buyer and seller that can be veried by evidence at the time of the transaction.
B. Assets normally remain on the books at their initial fair value or cost until they are
sold, expired, or consumed. Only for certain classes of assets will an adjustment be
made if there is evidence that the fair value has changed.
IV. Transactions must be classied according to the appropriate categories or accounts.
Summary
Before recording a business transaction, the accountant must determine three things:
00. When the transaction occurred (the recognition issue)
00. What value to place on the transaction (the valuation issue)
00. How the components of the transaction should be categorized (the classication
issue)
A sale is recognized (entered in the accounting records) when the title to merchandise
passes from the supplier to the purchaser, regardless of when payment is made or received.
This is called the recognition point.
The dollar value of any item involved in a business transaction is its original cost (also called
historical cost). Generally, any change in value subsequent to the transaction is not re.ected
in the accounting records. This practice, which conforms to the cost principle, is preferred
by accountants because the cost, or exchange price, is veriable and objective. The
exchange price results from an agreement between the buyer and seller that can be veried
by evidence created at the time of the transaction.
Every business transaction is classied by means of categories called accounts. Each asset,
liability, stockholders’ equity, revenue, and expense has a separate account.
Recognition, valuation, and classication are important factors in ethical nancial reporting.
These guidelines are intended to help managers meet their obligations to the company’s
owners and to the public.
Relevant Examples and Exhibits
Exhibit 1 Concepts Underlying Business Transactions
Teaching Strategy
Many students approach the topic of measurement (as well as accounting itself) as though it
is fairly cut-and-dried. Nevertheless, they must realize that there are often several ways to
approach the recognition, valuation, and classication issues, only one of which typically
follows GAAP. Emphasize that the recognition problem is not always easily solved and that
the historical cost principle is somewhat controversial.
Explain why a business transaction cannot be recorded until the three measurement issues
have been addressed.
Emphasize that as a user of nancial statements, it is important to understand that the
balance sheet does not aim to show what a business is worth. Give an example using land or
a building, which generally increases in value over time.
Mention some exceptions to the basic recognition rule of recording transactions only when
title transfers. Short Exercise 3 in the text illustrates this learning objective. You may also
present a basic journal entry and ask students to point out the portion of the journal entry
that refers to recognition, valuation, and classication. Short Exercise 2 provides an
excellent opportunity for students to integrate recognition, valuation, and classication
issues.
Section 2: Accounting Applications
Accounting Applications
Record business transactions
Prepare the trial balance
Lecture Outline
I0. Describe the nature of the double-entry system of accounting.
0. Principle of duality
II0. Accounts are the basic storage units for accounting data and are used to accumulate
amounts from similar transactions.
III0. Chart of accounts
A. An account is the basic storage unit for accounting data.
B0. An account occupies its own page in the general ledger.
C0. A chart of accounts lists all the accounts in the ledger.
D0. Discuss typical asset accounts, such as Cash, Accounts Receivable, Notes
Receivable, Supplies, Inventory, Prepaid Expenses, Land, Buildings, and
Equipment.
E0. Discuss typical liability accounts, such as Accounts Payable, Notes Payable, Wages
Payable, Income Taxes Payable, Rent Payable, Interest Payable, and Unearned
Revenue.
I0. A T account (the simplest form of an account) has three parts.
0. A title expressing the name of the asset, liability, etc.
0. A debit (left) side
0. A credit (right) side
V0. Demonstrate how account balances are determined.
VI0. State the rules of double entry.
0. Increases in assets are debited.
0. Decreases in assets are credited.
0. Increases in liabilities and owner’s equity are credited.
0. Decreases in liabilities and owner’s equity are debited.
0. Increases in revenues are credited.
0. Increases in expenses are debited.
I0. The normal balance of an account is what it takes (debit or credit) to increase the
account.
I0. Discuss typical owner’s equity accounts, such as Owner’s Capital and Withdrawals.
IX. There are six steps in the accounting cycle:
0. Analyze transactions from source documents to decide which account(s) to debit
and which account(s) to credit.
0. Journalize transactions.
0. Post entries to the ledger, and prepare a trial balance.
0. Make end-of-period adjustments, and prepare an adjusted trial balance.
E0. Prepare nancial statements.
F0. Close the accounts, and prepare a post-closing trial balance.
X0. Explain the ve-step process for analyzing and applying transactions.
0. State the transaction.
0. Analyze the transaction to determine which accounts are a-ected and how
(increased or decreased).
0. Apply the rules of double-entry accounting using T accounts to show how the
transaction a-ects the accounting equation.
0. Show the transaction in journal form.
0. Provide a comment that will help you apply the rules of double-entry accounting.
XI0. A trial balance tests the equality of debits and credits in the ledger before the nancial
statements are prepared. A three-step process is followed.
0. List each ledger account and its debit or credit balance.
0. Add each column.
0. Compare the column totals.
I0. If the trial balance does not balance, one or more of the following has occurred:
0. A debit was entered as a credit, or vice versa.
0. A balance was computed incorrectly.
0. A balance was carried to the trial balance incorrectly.
0. The trial balance was summed incorrectly.
III0. It is possible to make an error in the records that does not cause the trial balance to be
out of balance, such as the following:
0. A transaction was omitted or entered twice.
0. Both debit and credit amounts are incorrect but equal.
0. The wrong account was debited or credited.
XIV. General Journal
A0. Transactions are initially recorded in the journal (book of original entry).
B0. Every journal entry contains ve components.
10. The date
20. The account names
30. The dollar amounts debited and credited
40. An explanation
50. The account identication number or checkmark, as appropriate after posting
C0. A space should be skipped between journal entries.
D0. A compound entry is an entry with more than one debit or credit.
E0. Illustrate the ledger account form, and state its advantage over the T account
form.
XV0. Journal entries are posted (transferred) to the ledger when convenient (usually daily).
0. Post the date and amounts.
0. Compute a new account balance.
0. Place the journal page number in the Post. Ref. column of the ledger account.
0. Place the account number in the Post. Ref. column of the journal.
XVI0. Rules and customs regarding ruled lines, dollar signs, commas, and periods should be
followed.
Summary
The double-entry system of accounting requires that each transaction be recorded with at
least one debit and one credit, and that the total dollar amount of the debits must equal the
total amount of the credits.
Accounts are the basic storage units for accounting data and are used to accumulate
amounts from similar transactions. All of a company’s accounts are contained in a book
called the general ledger, or simply the ledger. In a manual system, each account appears
on a separate page, and the accounts generally are in the following order: assets, liabilities,
owner’s equity, revenues, and expenses. A listing of the accounts with their respective
account numbers, called a chart of accounts, is presented at the beginning of the ledger
for easy reference.
Although the accounts used by companies vary, some are common to most businesses.
Typical asset accounts are Cash, Accounts Receivable, Notes Receivable, Prepaid Expenses,
Land, Buildings, and Equipment. Typical liability accounts are Accounts Payable and Notes
Payable.
An account in its simplest form, a T account, has three parts:
00. A title, which identies the asset, liability, or owner’s equity account
00. A left side, which is called the debit side
00. A right side, which is called the credit side
At the end of an accounting period, the accountant must determine the account balance in
each account to prepare the nancial statements. Three steps are followed to determine
account balances:0
00. Foot (add up) the debit entries. The footing (total) should be written in small numbers
beneath the last entry.
00. Foot the credit entries.
00. Subtract the smaller total from the larger. A debit balance exists when total debits
exceed total credits; a credit balance exists when the opposite is the case.
To determine which accounts are debited and which are credited in a given transaction, the
accountant uses the following rules:0
00. Increases in assets are debited.
00. Decreases in assets are credited.
00. Increases in liabilities and owner’s equity are credited.
00. Decreases in liabilities and owner’s equity are debited.
00. Revenues increase owner’s equity and are therefore credited.
00. Expenses decrease owner’s equity and are therefore debited.
When more increases than decreases have been recorded for an account (the usual case),
its balance (debit or credit) is referred to as its normal balance. For example, assets have a
normal debit balance. Typical owner’s equity accounts are Owner’s Capital and Withdrawals.
A separate account is kept for each type of revenue and expense. The exact revenue and
expense accounts used vary depending on the type of business and the nature of its
operations.
The steps in the accounting cycle are as follows:
10. Analyze business transactions from source documents.
20. Record the entries in the journal.
30. Post the entries to the ledger, and prepare a trial balance.
40. Adjust the accounts, and prepare an adjusted trial balance.
50. Prepare nancial statements.
60. Close the accounts and prepare a post-closing trial balance.
Analyzing and applying transactions is a ve-step process:
00. State the transaction.
20. Analyze the transaction to determine which accounts are a-ected. Information about
transactions comes from source documents, such as invoices, checks, receipts, and
contracts.
30. Apply the rules of double-entry accounting by using T accounts to show how the
transaction a-ects the accounting equation.
40. Show the transaction in journal form. In journal form, the date, the debit account, and
the debit amount are recorded on one line and the credit account (indented) and credit
amount are recorded on the next line.
50. Provide a comment that will help you apply the rules of double-entry accounting.
The following journal entries are introduced in this section:
Cash XX (amount invested)
Owner’s Capital XX (amount invested)
Owner invested cash in the business
Prepaid Rent XX (amount paid)
Cash XX (amount paid)
Paid rent in advance
OHce Supplies XX (amount paid)
Accounts Payable XX (amount paid)
Purchase of oHce supplies on credit
OHce Equipment XX (purchase price)
Cash XX (amount paid)
Accounts Payable XX (amount to be paid)
Purchased oHce equipment with partial payment
Accounts Payable XX (amount paid)
Cash XX (amount paid)
Made partial payment on a liability
Cash XX (amount received)
Design Revenue XX (amount earned)
Received payment for services rendered
Accounts Receivable XX (amount to be received)
Design Revenue XX (amount earned)
Rendered service on credit
Cash XX (amount received)
Unearned Design Revenue XX (amount to be
earned)
Received payment for services to be performed
Cash XX (amount received)
Accounts Receivable XX (amount received)
Received payment for services previously performed
Wages Expense XX (amount incurred)
Cash XX (amount paid)
Paid wages for the period
Utilities Expense XX (amount incurred)
Accounts Payable XX (amount to be paid)
Received utility bill to be paid later
Owner’s Withdrawals XX (amount withdrawn)
Cash XX (amount paid)
Owner withdrew cash from business
Before nancial statements are prepared, the accountant must double-check the equality of
the debits and credits in the accounts. This is done formally by means of a trial balance. If
the trial balance does not balance, one or more errors have been made in the journal,
ledger, or trial balance. Once the errors have been located and the trial balance is in
balance, the nancial statements can be prepared. It is possible, however, to make errors
that do not cause the trial balance to be out of balance (that is, errors that are not detected
through the trial balance).
As transactions occur, they are recorded initially and chronologically in a book called the
journal. The general journal is the simplest and most .exible type of journal. Each
transaction journalized (recorded) in the general journal contains (1) the date, (2) the
account names, (3) the dollar amounts debited and credited, (4) an explanation, and (5) the
account identication numbers or checkmarks, as appropriate after posting. A line should be
skipped between each journal entry, and more than one debit or credit may be entered for a
single transaction.
In the construction of a ledger in practice, the ledger account form, rather than the T
account form, is used. The four-column type is illustrated in the text.
All journal entries must be posted to the ledger accounts. Posting is a transferring process
that results in an updated balance for each account. Not only must the dates and amounts
be transferred and new account balances computed, but the Post. Ref. columns must also be
used for cross-referencing between the journal and the ledger.
Ruled lines appear in nancial reports before each subtotal, and a double line is customarily
placed below the nal amount. Although dollar signs are required in nancial statements, they
are omitted in journals and ledgers. On ruled paper, commas and periods are omitted, and a
dash is customarily used to designate zero cents.
Relevant Examples and Exhibits
Exhibit 2 Chart of Accounts for a Small Business
Exhibit 3 Normal Account Balances of Major Account Categories
Exhibit 4 Relationships of Owner’s Equity Accounts
Exhibit 5 Overview of the Accounting Cycle
Exhibit 6 Summary of Transactions of Blue Design Studio
Exhibit 7 Trial Balance
Exhibit 8 The General Journal
Exhibit 9 Accounts Payable in the General Ledger
Exhibit 10 Posting from the General Journal to the Ledger
Exhibit 11 Formatting Guidelines
Exhibit 12 Transaction E-ects on Accounting Equation
