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Chapter 3:Chapter 3:ProcessingProcessing

Accounting InformationAccounting Information

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Transaction AnalysisTransaction Analysis

The first step in the accounting process is transaction analysis.

This process examines relevant, objectively measurable economic events through their effect on the accounting equation:

Assets = Liabilities + Equity

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Transaction AnalysisTransaction AnalysisAll business transactions will have an effect

on at least 2 items in the accounting equation.

For example, if you buy a car with cash, you decrease one asset (cash) and increase another asset (auto).

If you purchased a car by signing a note, you would increase an asset (auto), and increase a liability (notes payable).

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Class ProblemClass Problem

Using a spreadsheet approach, analyze the transactions listed on the next slide.

Note that effects may be on both sides of the equation (in the same direction), or effects may be on one side of the equation with offsetting directions.

Each transaction will affect at least 2 items in the accounting equation.

The equation will still be in balance after the transaction is posted.

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Class Problem - TransactionsClass Problem - TransactionsThe following activities were during the first month of

operation of Cordova Repair Company:1. The owners of Cordova Repair Company

contributed $20,000 cash in exchange for stock ownership in the company.

2. Cordova purchased equipment which cost $20,000. Cordova paid $8,000 cash and financed the balance at the bank.

3. Cordova completed repair services on a fleet of automobiles for Collierville Corporation, and billed Collierville $8,000 for the services.

4. Cordova paid rent expense of $5,000 for the month.

5. Cordova collected $4,000 from Collierville Co.6. Cordova distributed a $500 dividend to its

shareholders.

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Class Problem -SpreadsheetClass Problem -Spreadsheet

Cash + A/R + Equip. = N/P + CS + RE

1. =

2. =

3. =

4. =

5. =

6. _____ _____ _____= _____ _____ _____

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Class Problem: Financial StatementsClass Problem: Financial Statements

Income Statement

Revenues $8,000

Expenses 5,000

Net Income $3,000

Statement of Retained Earnings

RE (beginning) $ 0

Add: Net Income 3,000

Less: Dividends (500)

RE (ending) $2,500

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Class Problem: Financial StatementsClass Problem: Financial Statements Balance SheetAssets Cash $10,500

A/R 4,000 Equipment $20,000 Total $34,500 Liabilities and S.E.

N/P $ 12,000CS 20,000RE (ending) 2,500Total $34,500

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The Accounting ProcessThe Accounting ProcessThe first step in the accounting process is

transaction analysis.The second step is the recording of transactions

and events (journal entries).The third step is the posting of the information to

the ledger accounts (general ledger).The fourth step is the preparation of the trial

balance (this is used to construct the financial statements).

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The Double Entry System The Double Entry System

Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is not sufficient.

Therefore accountants use a “double entry” system based on debits and credits.

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Double Entry AccountingDouble Entry Accounting

Debit (dr) - means an entry to the left hand side of an account.

Credit (cr) - means an entry to the right hand side of an account.

Note that a debit or credit, per se, does not indicate increase or decrease.

To decide the effect of a debit or credit, the type of account must be considered.

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Effect of Debits and CreditsEffect of Debits and CreditsBased on the accounting equation, we can

increase or decrease various accounts depending on their classification:

Assets = Liabilities + Equity

Increase DR = CR CR

Decrease CR = DR DRNote that we use debits and credits

instead of plusses and minuses.Note, also, that bank terminology is

reversed from the customer perspective.

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The following rules can be derived from The following rules can be derived from the basic formula:the basic formula:Assets have normal debit balances and are

increased with a debit.Liabilities and equities have normal credit

balances and are increased with a credit.Revenues (a part of equity) have normal credit

balances and are increased with a credit.Expenses (which decrease equity) have normal

debit balances and are increased with a debit. Dividends (which decrease equity) have a

normal debit balance and are increased with a debit.

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The Format of a Journal EntryThe Format of a Journal Entry To initially record transactions, we use a journal

entry to represent the debits and credits. For example, in the Chapter 3 Class Problem,

Item 1: Debit Credit

Cash 20,000 Common Stock 20,000

Note that the debit is to the left and the credit is to the right. First we list the account (left hand entry on top), then the amount.

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Now back to the Class Problem and Now back to the Class Problem and prepare the other journal entries:prepare the other journal entries:

2: Purchased equip. costing $20,000.

3: Billed customer $8,000.

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Now back to the Class Problem, and Now back to the Class Problem, and prepare the other journal entries:prepare the other journal entries:

4: Paid $5,000 cash for expenses.

5: Collected $4,000 from customer.

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Now back to the Class Problem, and Now back to the Class Problem, and prepare the other journal entries:prepare the other journal entries:

6: Paid $500 cash dividend to owners.

Note that dividends is a contra equity and reduces retained earnings.

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The Accounting CycleThe Accounting CycleComponents of the basic accounting cycle

include:A. Preparation of Journal Entries (Chapter 3) -Post to the General Ledger -Unadjusted Trial BalanceB. Preparation of Adjusting Journal Entries

(Chapter 4) -Post to the General Ledger

-Adjusted Trial BalanceC. Financial Statements (Chapter 4)D. Closing Journal Entries (Chapter 4) -Post ClosingTrial Balance

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A. General Journal Entries (GJEs)A. General Journal Entries (GJEs) The first step in the accounting process. Prepared for daily activity. Usually journalized in special journals for

efficiency, but we will record in “General Journal” format.

Identified through a document flow:– cash receipt, record a cash sale– charge receipt, record a sale on account– bank note, record a notes payable– employee time card, record wages

The Journal Entries from the Class Problem are GJEs.

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The General Ledger (G/L)The General Ledger (G/L)The G/L serves as a place to “total”

amounts by account titles.After GJEs (and later – adjusting journal

entries) are recorded, they are posted (by account) to the G/L.

We will use “T” accounts to represent G/L accounts where needed.

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Back to Class Problem: Posting to G/LBack to Class Problem: Posting to G/LNow post transactions (for Cash) to “T” account:Now post transactions (for Cash) to “T” account:

Cash

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Unadjusted Trial BalanceUnadjusted Trial BalanceTrial balances are prepared throughout the

accounting cycle. The Unadjusted Trial Balance represents G/L

totals (by account) at a particular point in time. From the Chapter 3 Class Problem, the

Unadjusted Trial Balance would consist of a list of all of the ending debit or credit balances taken from the various “T” account totals (illustrated on the next slide).

The Unadjusted Trial Balance is a preliminary total, and is a starting point for the Adjusting Journal Entries (discussed in next chapter).

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Unadjusted Trial Balance – Class ProblemUnadjusted Trial Balance – Class Problem(after posting and totaling G/L accounts)(after posting and totaling G/L accounts)

Debit CreditCash 10,500Accounts Receivable 4,000

Equipment 20,000 Notes Payable 12,000

Common Stock 20,000 Retained Earnings-Begin 0

Revenues 8,000Expenses 5,000Dividends 500

Totals 40,000 40,000

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Unadjusted Trial BalanceUnadjusted Trial Balance

The Unadjusted Trial Balance is the starting point for the financials, but other analyses must be performed and recorded before the financial statements are complete.

These analyses are discussed in Chapter 4.