Chapter 2: ANALYZING TRANSACTIONS PDF

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2 ANALYZING TRANSACTIONS objectives After studying this chapter, you should be able to:

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Explain why accounts are used to record and summarize the effects of transactions on financial statements. Describe the characteristics of an account. List the rules of debit and credit and the normal balances of accounts. Analyze and summarize the financial statement effects of transactions. Prepare a trial balance and explain how it can be used to discover errors. Discover errors in recording transactions and correct them. Use horizontal analysis to compare financial statements from different periods.

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ssume that you have been hired by a pizza restaurant to deliver pizzas, using your own car. You will be paid $6.00 per hour plus $0.30 per mile plus tips. What is the best way for you to determine how many miles you have driven each day in delivering pizzas? One method would be to record the odometer mileage before work and then at quitting time. The difference would be the miles driven. For example, if the odometer read 56,743 at the start of work and 56,889 at the end of work, you would have driven 146 miles. This method is subject to error, however, if you copy down the wrong reading or make a math error. In the same way, business managers need information about the status of the business at different points in time. Such information is useful for analyzing the effects of transactions on the business and for making decisions. For example, the manager of your neighborhood dry cleaners needs to know how much cash is available, how much has been spent, and what services have been provided. In Chapter 1, we analyzed and recorded this kind of information by using the accounting equation, Assets ⫽ Liabilities ⫹ Owners’ Equity. Since such a format is not practical for most businesses, in Chapter 2 we will study more efficient methods of recording transactions. We will conclude this chapter by discussing how accounting errors may occur and how they may be detected by the accounting process.

Usefulness of an Account objective

1

Explain why accounts are used to record and summarize the effects of transactions on financial statements.

The increases and decreases in each financial statement item are shown in an account.

Before making a major cash purchase, such as buying a digital camera, you need to know the balance of your bank account. Likewise, managers need timely, useful information in order to make good decisions about their businesses. How are accounting systems designed to provide this information? We illustrated a very simple design in Chapter 1, where transactions were recorded and summarized in the accounting equation format. However, this format is difficult to use when thousands of transactions must be recorded daily. Thus, accounting systems are designed to show the increases and decreases in each financial statement item in a separate record. This record is called an account. For example, since cash appears on the balance sheet, a separate record is kept of the increases and decreases in cash. Likewise, a separate record is kept of the increases and decreases for supplies, land, accounts payable, and the other balance sheet items. Similar records would be kept for income statement items, such as fees earned, wages expense, and rent expense. A group of accounts for a business entity is called a ledger. A list of the accounts in the ledger is called a chart of accounts. The accounts are normally listed in the order in which they appear in the financial statements. The balance sheet accounts are usually listed first, in the order of assets, liabilities, and owners’ equity. The income statement accounts are then listed in the order of revenues and expenses. Each of these major account classifications is briefly described below. Assets are resources owned by the business entity. These resources can be physical items, such as cash and supplies, or intangibles that have value, such as patent rights. Some other examples of assets include accounts receivable, prepaid expenses (such as insurance), buildings, equipment, and land. Liabilities are debts owed to outsiders (creditors). Liabilities are often identified on the balance sheet by titles that include the word payable. Examples of liabilities include accounts payable, notes payable, and wages payable. Cash received before services are delivered creates a liability to perform the services. These future service commitments are often called unearned revenues. Examples of unearned revenues are magazine subscriptions received by a publisher and tuition received by a college at the beginning of a term. Owners’ equity is the owners’ right to the assets of the business. For a corporation, the owners’ equity on the balance sheet is called stockholders’ equity and

Chapter 2 • Analyzing Transactions

Procter & Gamble’s account numbers have over 30 digits to reflect P&G’s many different operations and regions.

•Exhibit 1

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is represented by the balance of the capital stock and retained earnings accounts. A dividends account represents distributions of earnings to stockholders. Revenues are increases in owners’ equity as a result of selling services or products to customers. Examples of revenues include fees earned, fares earned, commissions revenue, and rent revenue. The using up of assets or consuming services in the process of generating revenues results in expenses. Examples of typical expenses include wages expense, rent expense, utilities expense, supplies expense, and miscellaneous expense. A chart of accounts is designed to meet the information needs of a company’s managers and other users of its financial statements. The accounts within the chart of accounts are numbered for use as references. A flexible numbering system is normally used, so that new accounts can be added without affecting other account numbers. Exhibit 1 is NetSolutions’ chart of accounts that we will be using in this chapter. Additional accounts will be introduced in later chapters. In Exhibit 1, each account number has two digits. The first digit indicates the major classification of the ledger in which the account is located. Accounts beginning with 1 represent assets; 2, liabilities; 3, stockholders’ equity; 4, revenue; and 5, expenses. The second digit indicates the location of the account within its class.

Chart of Accounts for NetSolutions

11 12 14 15 17 18 21 23 31 32 33

1. Assets Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment 2. Liabilities Accounts Payable Unearned Rent 3. Owners’ (Stockholders’) Equity Capital Stock Retained Earnings Dividends

4. Revenue 41 Fees Earned 5. Expenses 51 Wages Expense 52 Rent Expense 54 Utilities Expense 55 Supplies Expense 59 Miscellaneous Expense

Characteristics of an Account objective

2

Describe the characteristics of an account.

An account, in its simplest form, has three parts. First, each account has a title, which is the name of the item recorded in the account. Second, each account has a space for recording increases in the amount of the item. Third, each account has a space for recording decreases in the amount of the item. The account form presented below is called a T account because it resembles the letter T. The left side of the account is called the debit side, and the right side is called the credit side. 1 Title Left side debit

Right side credit

Amounts entered on the left side of an account, regardless of the account title, are called debits to the account. When debits are entered in an account, the account is said to be debited (or charged). Amounts entered on the right side of an account 1The

terms debit and credit are derived from the Latin debere and credere.

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Chapter 2 • Analyzing Transactions

Many times when accountants analyze complex transactions, they use T accounts to simplify the thought process. In the same way, you will find T accounts a useful device in this and later accounting courses.

Amounts entered on the left side of an account are debits, and amounts entered on the right side of an account are credits.

are called credits, and the account is said to be credited. Debits and credits are sometimes abbreviated as Dr. and Cr. In the cash account that follows, transactions involving receipts of cash are listed on the debit side of the account. The transactions involving cash payments are listed on the credit side. If at any time the total of the cash receipts is needed, the entries on the debit side of the account may be added and the total ($10,950) inserted below the last debit. 2 The total of the cash payments, $6,850 in the example, may be inserted on the credit side in a similar manner. Subtracting the smaller sum from the larger, $10,950 ⫺ $6,850, identifies the amount of cash on hand, $4,100. This amount is called the balance of the account. It may be inserted in the account, next to the total of the debit column. In this way, the balance is identified as a debit balance. If a balance sheet were to be prepared at this time, cash of $4,100 would be reported. Cash 3,750 4,300 2,900

Debit side of account 4,100

850 1,400 700 2,900 1,000

10,950

Credit side of account

6,850 Balance of account (Total debits ⫺ Total credits)

Total debits Total credits

A innalyzing and Summarizing Transactions Accounts objective

3

List the rules of debit and credit and the normal balances of accounts.

Every transaction affects at least two accounts.

Every business transaction affects at least two accounts. To illustrate how transactions are analyzed and summarized in accounts, we will use the NetSolutions transactions from Chapter 1, with dates added. First, we illustrate how transactions (a), (b), (c), and (f) are analyzed and summarized in balance sheet accounts (assets, liabilities, and stockholders’ equity). Next, we illustrate how transactions (d), (e), and (g) are analyzed and summarized in income statement accounts (revenues and expenses). Finally, we illustrate how the payment of dividends, transaction (h), is analyzed and summarized in the accounts.

Balance Sheet Accounts Chris Clark’s first transaction, (a), was to deposit $25,000 in a bank account in the name of NetSolutions in exchange for capital stock. The effect of this November 1 transaction on the balance sheet is to increase assets and stockholders’ equity, as shown below.

NetSolutions Balance Sheet November 1, 2005 Assets Cash

Stockholders’ Equity $25 0 0 0 00

Capital Stock

$25 0 0 0 00

2This amount, called a memorandum balance, should be written in small figures or identified in some other way to avoid mistaking the amount for an additional debit.

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Chapter 2 • Analyzing Transactions

A journal can be thought of as being similar to an individual’s diary.

This transaction is initially entered in a record called a journal. The title of the account to be debited is listed first, followed by the amount to be debited. The title of the account to be credited is listed below and to the right of the debit, followed by the amount to be credited. This process of recording a transaction in the journal is called journalizing. This form of recording a transaction is called a journal entry. The journal entry for transaction (a) is shown below.

JOURNAL Date

Entry A

1

Post. Ref.

Description

2005

Nov. 1

2

Page 1

Cash Capital Stock

Debit

Credit

2 5 0 0 0 00

1

2 5 0 0 0 00 2

Issued capital stock for cash.

3

3

The increase in the asset (Cash), which is reported on the left side of the balance sheet, is debited to the cash account. The increase in stockholders’ equity (capital stock), which is reported on the right side of the balance sheet, is credited to the capital stock account. As other assets are acquired, the increases are also recorded as debits to asset accounts. Likewise, other increases in stockholders’ equity will be recorded as credits to stockholders’ equity accounts. The effects of this transaction are shown in the accounts by transferring the amount and date of the journal entry to the left (debit) side of Cash and to the right (credit) side, Capital Stock, as follows: Cash Nov. 1

Capital Stock

25,000

Nov. 1

25,000

On November 5 (transaction b), NetSolutions bought land for $20,000, paying cash. This transaction increases one asset account and decreases another. It is entered in the journal as a $20,000 increase (debit) to Land and a $20,000 decrease (credit) to Cash, as shown below. Entry B

4 5 6 7

4

5

Land Cash Purchased land for building site.

2 0 0 0 0 00

5

2 0 0 0 0 00 6 7

The effect of this entry is shown in the accounts of NetSolutions as follows: Cash

Land

Nov. 1 25,000 Nov. 5 20,000

Capital Stock

Nov. 5 20,000

Nov. 1 25,000

On November 10 (transaction c), NetSolutions purchased supplies on account for $1,350. This transaction increases an asset account and increases a liability account. It is entered in the journal as a $1,350 increase (debit) to Supplies and a $1,350 increase (credit) to Accounts Payable, as shown below. To simplify the illustration, the effect of entry (c) and the remaining journal entries for NetSolutions will be shown in the accounts later. Entry C

8 9 10 11

8

10 Supplies Accounts Payable Purchased supplies on account.

1 3 5 0 00

9

1 3 5 0 00 10 11

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Chapter 2 • Analyzing Transactions

On November 30 (transaction f), NetSolutions paid creditors on account, $950. This transaction decreases a liability account and decreases an asset account. It is entered in the journal as a $950 decrease (debit) to Accounts Payable and a $950 decrease (credit) to Cash, as shown below. Entry F

23 24

23

30 Accounts Payable Cash

25

9 5 0 00 25

Paid creditors on account.

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The left side of all accounts is the debit side, and the right side is the credit side.

24

9 5 0 00

26

In the preceding examples, you should observe that the left side of asset accounts is used for recording increases and the right side is used for recording decreases. Also, the right side of liability and owners’ (stockholders’) equity accounts is used to record increases, and the left side of such accounts is used to record decreases. The left side of all accounts, whether asset, liability, or owners’ equity, is the debit side, and the right side is the credit side. Thus, a debit may be either an increase or a decrease, depending on the account affected. Likewise, a credit may be either an increase or a decrease, depending on the account. The general rules of debit and credit for balance sheet accounts may be thus stated as follows:

Asset accounts . . . . . . . . . . . . . . . . . . . . . . . Liability accounts . . . . . . . . . . . . . . . . . . . . . Owners’ (stockholders’) equity accounts . . . .

Debit

Credit

Increase (⫹) Decrease (⫺) Decrease (⫺)

Decrease (⫺) Increase (⫹) Increase (⫹)

The rules of debit and credit for balance sheet accounts may also be stated in relationship to the accounting equation, as shown below. Balance Sheet Accounts LIABILITIES Liability Accounts

ASSETS Asset Accounts Debit for increases (⫹)

Credit for decreases (⫺)

Debit for decreases (⫺)

Credit for increases (⫹)

OWNERS’ EQUITY Stockholders’ Equity Accounts Debit for decreases (⫺)

Credit for increases (⫹)

Income Statement Accounts The analysis of revenue and expense transactions focuses on how each transaction affects stockholders’ equity (retained earnings). Just as increases in capital stock are recorded as credits, so, too, are increases in retained earnings. Because revenue transactions increase retained earnings, increases in revenues are recorded as credits. Similarly, because expense transactions decrease retained earnings, increases in expenses are recorded as debits. We will use NetSolutions’ transactions (d), (e), and (g) to illustrate the analysis of transactions and the rules of debit and credit for revenue and expense accounts. On November 18 (transaction d), NetSolutions received fees of $7,500 from customers for services provided. This transaction increases an asset account and in-

Chapter 2 • Analyzing Transactions

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FINANCIAL REPORTING AND DISCLOSURE THE HIJACKING RECEIVABLE

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company’s chart of accounts should reflect the basic nature of its operations. Occasionally, however, transactions take place that give rise to unusual accounts. The following is a story of one such account. During the early 1970s, before strict airport security was implemented across the United States, several airlines experienced hijacking incidents. One such incident occurred on November 10, 1972, when a Southern Airways DC-9 en route from Memphis to Miami was hijacked during a stopover in Birmingham, Alabama. The three hijackers boarded the plane in Birmingham armed with handguns and hand grenades. At gunpoint, the hijackers took the plane, the plane’s crew of four, and 27 passengers to nine American cities, Toronto, and eventually to Havana, Cuba. During the long flight, the hijackers threatened to crash the plane into the Oak Ridge, Tennessee, nuclear facilities, insisted on talking with President Nixon, and demanded a ransom of $10 million. Southern Airways, however, was only able to come up with $2 million. Eventually, the pilot

talked the hijackers into settling for the $2 million when the plane landed in Chattanooga for refueling. Upon landing in Havana, the Cuban authorities arrested the hijackers and, after a brief delay, sent the plane, passengers, and crew back to the United States. The hijackers and $2 million stayed in Cuba. How did Southern Airways account for and report the hijacking payment in its subsequent financial statements? As you might have analyzed, the initial entry credited Cash for $2 million. The debit was to an account entitled “Hijacking Payment.” This account was reported as a type of receivable under “other assets” on Southern’s balance sheet. The company maintained that it would be able to collect the cash from the Cuban government and that, therefore, a receivable existed. In fact, in August 1975, Southern Airways was repaid $2 million by the Cuban government, which was, at that time, attempting to improve relations with the United States.

creases a revenue account. It is entered in the journal as a $7,500 increase (debit) to Cash and a $7,500 increase (credit) to Fees Earned, as shown below. Entry D

12 13 14 15

12

18 Cash

7 5 0 0 00

Fees Earned Received fees from customers.

13

7 5 0 0 00 14 15

Throughout the month, NetSolutions incurred the following expenses: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275. To simplify the illustration, the entry to journalize the payment of these expenses is recorded on November 30 (transaction e), as shown below. This transaction increases various expense acco...