FINANCIAL ACCOUNTING

CHAPTER TWO

Companies transact business everyday. All business transactions involve an exchange. Transactions are the economic events, the exchanges that have a measurable impact on the financial position of the business.

The key summary device of accounting is the account. This is a detailed record of all the changes that have occurred in a particular asset, liability, or owners’ equity as a result of transactions.

Assets are the economic resources of a business expected to provide benefits to the business in the future.

1. Cash – cash includes money, such as the business’s bank account balance, paper currency, coins, and checks

2. Accounts receivable – A business may sell goods or services in exchange for an oral or implied promise of future cash receipts. This account holds the amounts that customers owe the business for goods or services that have already been provided.

3. Notes receivable – A business may sell goods or services or loan money and receive a promissory note. A note receivable is a written pledge that the customer or borrower will pay a fixed amount of money by a certain date.

4. Prepaid expenses – A business often pays a certain expense (rent or insurance) in advance. A prepaid expense is an asset because the prepayment provides a future benefit for the business.

5. Land – This account is a record of the cost of land a business owns and uses in its operations.

6. Buildings – The cost of a business’s buildings, its offices, warehouses, and stores will be in this account.

7. Equipment – A business has a separate asset account for each type of equipment (computer equipment, office equipment, store equipment.)

8. Furniture – office furniture, store furniture

9. Fixtures – store fixtures, office fixtures)

Liabilities are debts owed to outsiders. Liabilities are often identified on the balance sheet by titles that include the word payable.

1. Accounts payable – A business may purchase goods or services in exchange for an oral or implied promise of future payment. The accounts payable account shows how much cash the business must pay suppliers for goods or services that have already been received.

2. Notes payable – Notes payable represents amounts the business must pay because it signed promissory notes to borrow money or purchase goods or services.

3. Accrued liabilities – An accrued liability is a liability for an expense that has been incurred but has not yet been paid (taxes payable, interest payable, salary payable.)

The owners’ claim to the assets of the business is called owners’ equity. In a corporation owners’ equity is called stockholders’ equity.

1. Common stock – This account is used to account for stock sold to stockholders.

2. Retained earnings – This account tracks the cumulative earnings of the business since it began, less any dividends given to stockholders.

3. Revenues – The increase in retained earnings created by selling goods or services to customers. This account represents amounts earned by the company even if the company has not yet been paid for the goods or services provided.

4. Expenses – Expenses are the decreases in retained earnings from using resources to deliver goods or provide services to customers.

5. Dividends – This account holds the amount of earnings that are distributed to the owners of the corporation, the stockholders. Dividends decrease retained earnings.

Organizations use a chart of accounts to list all their accounts along with the numbers they assign to them. Accounts are listed in the chart of accounts in the balance sheet order of assets, liabilities, stockholders’ equity, revenues, and expenses. Account numbers usually have two or more digits. The first digit indicates the type of account. The second and third digits in an account number indicate where the account fits within the category. There are usually gaps in the numbers on the chart of accounts. This allows for other accounts to be added later.

Transactions demonstrate that an exchange occurred between the business and an entity outside of the business. The accounts provide a summary of all the exchanges, or transactions, that affect the accounts for the accounting period. The rule that reflects the fact that every transaction involves al least two accounts is called double-entry accounting.

DEBITS AND CREDITS

The left side of any account is called the debit side (Dr). The right side of any account is called the credit side (Cr.) To debit an account simply means putting a transaction on its left side; to credit an account means putting an entry on its right side. To show that every transaction affects at least two accounts, every business transaction will include at least one debit and at least one credit. Equal amounts of debits and credits represent every transaction.

A T-account is an informal account form used to summarize transactions. The T-account gets its name from the fact that it is shaped like the letter “T”.

The type of account determines where we record increases and decreases in the T-account.

1. Assets – increases are placed on the left, or debit side, and decreases are placed on the right, or credit side.

2. Liabilities – increases are placed on the right, or credit side, and decreases are placed on the left, or debit side.

3. Stockholders’ equity – increases are placed on the right, or credit side, and decreases are placed on the left, or debit side (stock and retained earnings)

4. Revenues – increases are placed on the right, or credit side, and decreases are placed on the left, or debit side

5. Expenses – increases are placed on the left, or debit side, and decreases are placed on the right, or credit side

6. Dividends – increases are placed on the left, or debit side, and decreases are placed on the right, or credit side

An account’s normal balance falls on the side of the account where increases are recorded..

1. Assets – debit

2. Liabilities – credit

3. Common stock – credit

4. Retained earnings – credit

5. Revenues – Credit

6. Expenses – Debit

7. Dividends – Debit

The accounting process actually begins when business transactions are entered into a journal. The journal is the chronological record of the transactions of a business. The accounting system tracks each exchange by creating a record in the journal showing the transaction, the date it occurred, and how it affected the business’s accounts. Every journal entry includes an equal amount of debits and credits. To enter a transaction in a journal means to record or journalize the transaction. The following are the steps to record a journal entry:

1. Record the date

2. Record the debit entry by entering the account title and then entering the amount in the debit column

3. Record the credit entry on the next line by indenting the account title and then entering the amount in the credit column

4. Write an explanation describing the entry

The ledger is a grouping of all the accounts and their balances in balance sheet order to show the amount of assets, liabilities, and stockholders’ equity on a given date. A necessary step in the process of summarizing transactions is to post the transactions in the journal to the ledger. Posting, in accounting, means copying the amounts from the journal to the ledger. Debits in the journal are posted as debits in the ledger, and credits in the journal are credits in the ledger.

The journal has a column labeled “Post Ref”. This stands for posting reference, a notation that links the two records, the journal and the ledger, together. When posting the amount from the journal to the ledger, place the account numbers of the accounts to which the entry was posted in the Post Ref column of the journal.

Applying Transaction Analysis – pages 66 – 76.

After transactions are recorded and posted to accounts, a balance of each account will be calculated. A balance is the difference between the account’s total debits and its total credits. If an account’s total debits are more than its total credits, then that account had a debit balance. If an account’s total credits are more that its total debits, then that account has a credit balance.

Once the transactions have been recorded in the journal and posted to the accounts in the ledger, a trial balance can be prepared. A trial balance lists all the accounts of a business and their balances in balance sheet order. A trial balance can be constructed at any time, but is most commonly made at the end of the accounting period. The purpose of a trial balance is to summarize all account balances to be certain that total debits equal total credits before the financial statements are prepared.

Trial Balance Errors

When recording and posting transactions, accounting errors can occur. The trial balance helps us find those errors that cause total debits and total credits to be unequal. To find an error, you start with the trial balance and work back through the accounting records. Errors can occur in the following activities:

1. Preparing the trial balance

2. Calculating account balances

3. Posting amounts into the accounts

4. Recording journal entries

Page 81 for 9 types of errors

Errors may still occur in the trial balance, even though total debits and credits are the same and the trial balance “balances.” A transaction could be recorded for the wrong amount in a journal entry, the entry could be recorded twice, or not recorded at all.

Correcting Errors in Trial Balance – page 83

After completing the trial balance, you can prepare the financial statements.