Chapter 2 (Analyzing Business Transaction)

Business Events: are economic events that affect a company’s financial position.
Business transactions: any occurrence related to the course of running a business.
Measurement of business Transaction: to measure a business transaction, you must decide when the
transaction occurred (the recognition issue), what value to place on the transaction (the valuation issue),
and how the components of the transaction should be categorized (the classification issue).

1. Recognition: In accounting, recognize means to record a transaction or event. The recognition

issue refers to the difficulty of deciding when a business transaction should be recorded. The
resolution of this issue is important because the date on which a transaction is recorded affects
amounts in the financial statements.
 recognition point: The predetermined time at which a transaction should be recorded.
2. Valuation: The valuation issue focuses on assigning a monetary value to a business transaction.
GAAP state that all business transactions should be valued at fair value when they occur (Original
cost, Historical Cost).
 Fair value: is defined as the exchange price of an actual or potential business transaction
between market participants.
 Cost principle: This practice of recording transactions at exchange price at the point of
recognition is commonly referred to as the cost principle. The principle that a purchased asset
should be recorded at its actual cost.
3. Classification: is the process of assigning transactions to the appropriate accounts. The
classification issue refers to the uncertainties associated with assigning transactions to the
appropriate accounts.
 Accounts:
 Accounts are the basic storage units for accounting data and are used to accumulate amounts from
similar transactions. An accounting system has a separate account for each asset, each liability, and
each component of owner’s equity, including revenues and expenses. An account title should
describe what is recorded in the account.
 The T Accounts:
 The T account is a good place to begin the study of the double-entry system. Such an account has
three parts: a title, which identifies the asset, liability, or owner’s equity account; a left side, which is
called the debit side; and a right side, which is called the
credit side. The T account, so called because it resembles the
letter T, is used to analyze transactions and is not part of the
accounting records. It looks like this:
  Accounting Methods:
 We have two methods of accounting:
1. Cash basis of Accounting: is a method for recording transaction, transactions are only recorded
when cash changes hands, revenue is recognized once cash is received, expanse are recorded
once cash is paid out.
2. Accruals basis of Accounting: transactions are recorded when they are happened, revenue is
recognized as its earned, expanse is recorded as they are incurred.
 Rules of Double Entry Accounting (Credit & debit Rules):
 The two rules of the double-entry system are that every transaction affects at least two accounts
and that total debits must equal total credits.

 Or (DEALOR) method:

Dividends + Expenses + Assets = Liabilities + Owners’ Equity + Revenue

Dr. ↑ Cr. ↑
Cr. ↓ Dr. ↓
 Normal Balance:
 The normal balance of an account is its usual balance and is the side (debit or credit) that increases the
account. Table 2-1 summarizes the normal account balances of the major account categories.
 Owners’ equity accounts:
 Figure 2-2 illustrates how owner’s equity accounts relate to each other and to the financial statements.
The distinctions among these accounts are important for both legal purposes and financial reporting.

 Business Transaction Analysis:

 For each transaction, we follow these steps:
1. State the transaction.
2. Analyze the transaction to determine which accounts are affected.
3. Apply the rules of double-entry accounting by using T accounts to show how the transaction affects
the accounting equation. It is important to note that this step is not part of the accounting records
but is undertaken before recording a transaction in order to understand the effects of the transaction
on the accounts.
4. Show the transaction in journal form. The journal form is a way of recording a transaction with the
date, debit account, and debit amount shown on one line, and the credit account (indented) and
credit amount on the next line. The amounts are shown in their respective debit and credit columns.
This step represents the initial recording of a transaction in the records and takes the following form:

5. Provide a comment that will help you apply the rules of double entry.
 General Journal: chronological record of the transactions called a general journal.
 General Ledger: Periodically, each debit and credit in an entry is transferred to its appropriate account in
a list of accounts called the general ledger.
 Examples= text book from page 58 - 65
 The trial Balance:
 For every amount debited, an equal amount must be credited. This means that the total of debits and
credits in the T accounts must be equal. To test this, the accountant periodically prepares a trial balance.
The trial balance proves whether the accounts are in balance. In balance means that the total of all debits
recorded equals the total of all credits recorded. But the trial balance does not prove that the
transactions were analyzed correctly or recorded in the proper accounts.
 Although a trial balance may be prepared at any time, it is usually prepared on the last day of the
 accounting period. The preparation involves these steps:
1) List each account that has a balance, with debit balances in the left column and credit balances in the
right column. Accounts are listed in the order in which they appear in the financial statements.
2) Add each column.
3) Compare the totals of the columns.

 Finding Trial Balance Errors:

 If the debit and credit balances in a trial balance are not equal, look for one or more of the following
errors:
1) A debit was entered in an account as a credit, or vice versa.
2) The balance of an account was computed incorrectly.
3) An error was made in carrying the account balance to the trial balance.
4) The trial balance was summed incorrectly.
5) Other than simply adding the columns incorrectly, the two most common mistakes in preparing a trial
balance are:
 Recording an account as a credit when it usually carries a debit balance, or vice versa. This mistake causes
the trial balance to be out of balance by an amount divisible by 2.
 Transposing two digits when transferring an amount to the trial balance (for example, entering $23,459
as $23,549). This error causes the trial balance to be out of balance by an amount divisible by 9.
 Recording and posting transactions;
 we described how transactions are analyzed according to the rules of double entry and how a trial
balance is prepared. The two intermediate steps are recording the entry in the general journal and
posting the entry to the ledger. In this section, we demonstrate how these steps are accomplished in a
manual accounting system.

 Charts of Accounts:
 chart of accounts is a table of contents for the ledger. Typically, it lists accounts in the order in which they
appear in the ledger, which is usually the order in which they appear in the financial statements. The
numbering scheme allows for some flexibility.
 General Journal:
 The journal is sometimes called the book of original entry because it is where transactions first enter the
accounting records. Later, the debit and credit portions of each transaction are transferred to the
appropriate accounts in the ledger.
A separate journal entry is used to
record each transaction; the process
of recording transactions is called
journalizing. Most businesses have
more than one kind of journal. The
simplest and most flexible kind is the
general journal, the one we focus on
here. Businesses will also
have several special-purpose
 journals, each for recording a common transaction, such as credit sales, credit purchases, cash receipts,
and cash disbursements.

in a general journal include the following information about each transaction:

1) The date. The year appears on the first line of the first column, the month on the next line of the first
column, and the day in the second column opposite the month. For subsequent entries on the same page
for the same month and year, the month and year can be omitted.
2) The names of the accounts debited and credited, which appear in the Description column. The names of
the accounts that are debited are placed next to the left margin opposite the dates; on the line below,
the names of the accounts credited are indented.
3) The debit amounts, which appear in the Debit column opposite the accounts that are debited, and the
credit amounts, which appear in the Credit column opposite the accounts credited.
4) An explanation of each transaction, which appears in the Description column below the account names.
An explanation should be brief but sufficient to explain and identify the transaction.
5) The account numbers in the Post. Ref. column, if they apply. At the time the transactions are recorded,
nothing is placed in the Post. Ref. (posting reference) column. (This column is sometimes called LP or
Folio.) Later, if the company uses account numbers to identify accounts in the ledger, the account
numbers are filled in. They provide a convenient cross-reference from the general journal to the ledger
and indicate that the entry has been posted to the ledger. If the accounts are not numbered, the
accountant uses a checkmark (✓) to signify that the entry has been posted.
 General Ledger:
 The general journal is used to record the details of each transaction. The general ledger is used to update
each account. The Ledger Account Form; The ledger account form, which contains four columns for dollar
amounts, is illustrated in Exhibit 2-5. The account title and number appear at the top of the account form.
As in the journal, the transaction date appears in the first two columns. The Item column is rarely used to
identify transactions because explanations already appear in the journal. The Post. Ref. column is used to
note the journal page on which the original entry for the transaction can be found. The dollar amount is
entered in the appropriate Debit or Credit column, and a new account balance is computed in the last
two columns opposite each entry. The advantage of this account form over the T account is that the
current balance of the account is readily available.

 Posting: After transactions have been entered in the journal, they must be transferred to the ledger. The
process of transferring journal entry information from the journal to the ledger is called posting. in
 posting, each amount in the Debit column of the journal is transferred to the Debit column of the
appropriate account in the ledger, and each amount in the Credit column of the journal is transferred to
the Credit column of the appropriate account in the ledger.
The steps in the posting process are as follows:
1) In the ledger, locate the debit account named in the journal entry.
2) Enter the date of the transaction in the ledger and, in the Post. Ref. column, the journal page number
from which the entry comes.
3) In the Debit column of the ledger account, enter the amount of the debit as it appears in the journal.
4) Calculate the account balance and enter it in the appropriate Balance column.
5) Enter in the Post. Ref. column of the journal the account number to which the amount has been posted.
6) Repeat the same five steps for the credit side of the journal entry. Notice that Step 5 is the last step in the
posting process for each debit and credit. As noted earlier, in addition to serving as an easy reference
between the journal entry and the ledger account, this entry in the Post. Ref. column of the journal
indicates that the entry has been posted to the ledgers.
Stop & Review
 To measure a business transaction, you must determine when the transaction occurred (the
recognition issue), what value to place on the transaction (the valuation issue), and how the
components of the transaction should be categorized (the classification issue). In general, recognition
occurs when title passes, and a transaction is valued at the exchange price—the fair value or cost at the
time the transaction is recognized. Classification refers to assigning transactions to the appropriate
accounts. GAAP provide guidance about the treatment of these three basic measurement issues.
Failure to follow these guidelines is a major reason some companies issue unethical financial
statements.
 In the double-entry system, each transaction must be recorded with at least one debit and one credit,
and the total amount of the debits must equal the total amount of the credits. Each asset, liability, and
component of owner’s equity, including revenues and expenses, has a separate account, which is a
device for storing transaction data. The T account is a useful tool for quickly analyzing the effects of
transactions. It shows how increases and decreases in assets, liabilities, and owner’s equity are debited
and credited to the appropriate accounts.
 The double-entry system is applied by analyzing transactions to determine which accounts are affected
and by using T accounts to show how the transactions affect the accounting equation. The transactions
may be recorded in journal form with the date, debit account, and debit amount shown on one line,
and the credit account (indented) and credit amount on the next line. The amounts are shown in their
respective debit and credit columns.
 A trial balance is used to check that the debit and credit balances are equal. It is prepared by listing
each account balance in the appropriate Debit or Credit column. The two columns are then added, and
the totals are compared. The major limitation of a trial balance is that even when it shows that debit
and credit balances are equal, it does not guarantee that the transactions were analyzed correctly or
recorded in the proper accounts.
 Some transactions generate immediate cash. For those that do not, there is a holding period in either
Accounts Receivable or Accounts Payable before the cash is received or paid. The timing of cash flows
is critical to a company’s ability to maintain adequate liquidity so that it can pay its bills on time.
 The chart of accounts is a list of account numbers and titles; it serves as a table of contents for the
ledger. The general journal is a chronological record of all transactions; it contains the date of each
transaction, the titles of the accounts involved, the amounts debited and credited, and an explanation
of each entry. After transactions have been entered in the general journal, they are posted to the
ledger. Posting is done by transferring the amounts in the Debit and Credit columns of the general
journal to the Debit and Credit columns of the corresponding account in the ledger. After each entry is
posted, a new balance is entered in the appropriate Balance column.