MNU

Principles of Accounting

Chapter-02: Analyzing and Recording Business Transactions

2.1: Introduction:
Accounting records include records of assets and liabilities, monetary transactions, ledgers,
journals, and any supporting documents such as checks and invoices. The recording process is
entering transactions in the general journal and posting them to the correct general ledger
accounts is time consuming. In the general journal, a simple transaction requires three lines - two
to list the accounts and one to describe the transaction. The transaction must then be posted to
each general ledger account. If the transaction affects a control account, the posting must be done
twice - once to the subsidiary ledger account and once to the controlling general ledger account.
Companies use a set of procedures and records to keep track of transaction data more easily. This
chapter introduces and illustrates these basic procedures and records.

2.2: Account:
An account is an accounting record of increase and decreases in a specific asset, liability, or
owner’s equity item. There are separate accounts for the items we used in transactions such as
cash, salaries expense, accounts payable, etc. Basic form of account is given below:

Debits and Credits:

 Debit indicates left and Credit indicates right.
 Recording $ on the left side of an account is debiting the account.
 Recording $ on the right side is crediting the account.
 If the total of debit amounts is bigger than credits, the account has a debit balance.
 If the total of credit amounts is bigger than debits, the account has a credit balance

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2.3: Debit and Credit Procedures:

If there is something that runs the world of accounting, it is the rules debit and credit. Without
these rules, the world of accounting would be a haphazard mess. It is important that the accounts
should be maintained properly on these rules, in order to ensure the accuracy of results displayed
by such books of accounts. Let us study what a debit and credit are and how it works in accounts.
Every business transaction which can be measured in monetary terms finds a place in the
accounting transactions of a firm. In order to record such transactions, a system of debit and
credit has been devised, which records such events through two different accounts.
The net effect of these accounting entries is the same in terms of quantity. However, by debiting
and crediting two different accounts, the correct and apt accounting treatment can be depicted. In
a ledger account, usually the debit column is on the left and the credit column is on the right.
Debit and Credit in Accounting:
A debit is an accounting entry that either increases an asset or expense account, or decreases a
liability or equity account. It is positioned on the left in an accounting entry.
A credit is an accounting entry that increases either a liability or equity account, or decreases an
asset or expense account. It is positioned on the right in an accounting entry.
Whenever an accounting transaction happens, a minimum of two accounts is always impacted,
with a debit entry being recorded against one account and a credit entry being recorded against
another account. There is no upper limit to the number of accounts involved in a transaction but
the minimum cannot be less than two accounts.
The totals of the debits and credits for any transaction must always equal each other so that an
accounting transaction is always said to be in balance. Thus, the use of debits and credits in a two
column transaction recording format is the most essential of all controls over accounting
accuracy. This is how debit and credit find their use.
Rules for Debit and Credit:
The following are the rules of debit and credit which guide the system of accounts, they are
known as the Golden Rules of accountancy:
 First: Debit what comes in, Credit what goes out.
 Second: Debit all expenses and losses, Credit all incomes and gains.
 Third: Debit the receiver, Credit the giver.
A debit and credit entry has a broad impact on different accounts. For example-
 In asset accounts: a debit increases the balance and a credit decreases the balance.
 In liability accounts: a debit decreases the balance and a credit increases the balance.
 In equity accounts: a debit decreases the balance and a credit increases the balance.
 In revenue accounts: a debit decreases the balance and a credit increases the balance.

2.4: Basic Accounting Equation:

The accounting equation is considered to be the foundation of the double-entry accounting
system. The accounting equation shows on a company's balance sheet whereby the total of all the
company's assets equals the sum of the company's liabilities and shareholders' equity. Based on

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this double-entry system, the accounting equation ensures that the balance sheet remains
“balanced,” and each entry made on the debit side should have a corresponding entry (or
coverage) on the credit side.
The double-entry system of accounting or bookkeeping means that for every business
transaction, amounts must be recorded in a minimum of two accounts. The double-entry system
also requires that for all transactions, the amounts entered as debits must be equal to the amounts
entered as credits.

An accounting transaction is a business activity or event that causes a measurable change in the
accounting equation. An exchange of cash for merchandise is a transaction. Merely placing an
order for goods is not a recordable transaction because no exchange has taken place.
Assets (what it owns)
Liabilities (what it owes to others)
Equity (the difference between assets and liabilities or what it owes to the owners)
These are the building blocks of the basic accounting equation. The accounting equation is:

ASSETS = LIABILITIES + EQUITY

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For Example:
A sole proprietorship business owes $12,000 and you, the owner personally invested $100,000 of
your own cash into the business. The assets owned by the business will then be calculated as:
$12,000 (what it owes) + $100,000 (what you invested) = $112,000 (what the company has in
assets)
Asset = Liabilities + Equity
$112,000 = $12,000 $100,000

In a sole-proprietorship, equity is actually Owner’s Equity. If the business in question is a

corporation, equity will be held by stockholders, which uses stockholder’s equity but the basic
equation is the same:

ASSETS = LIABILITIES + EQUITY

For Example:
A business owes $35,000 and stockholders (investors) have invested $115,000 by buying stock
in the company. The assets owned by the business will then be calculated as:
$35, 000 (what it owes) + $115,000 (what stockholders invested) = $150,000 (what the company
has in assets)
Assets = Liabilities + Equity
$150,000 = $35,000 $115,000

Since each transaction affecting a business entity must be recorded in the accounting records
based on a detailed account (remember, file folders and the chart of accounts from the previous
section), analyzing a transaction before actually recording it is an important part of financial
accounting. An error in transaction analysis could result in incorrect financial statements.

2.5: Steps in the recording process:

Recording is a basic phase of accounting that is also known as bookkeeping. Accounting
recorders are the documents and books involved in preparing financial statements. Accounting
recorders include records of assets, liabilities, ledgers, journals, and other supporting documents
such as invoices and checks. The basic steps in the recording process are:
a) Analyze each transaction for its effects on the accounts.
b) Enter the transaction information in a journal.
c) Transfer the journal information to be appropriate accounts in the ledger.

2.6: Journal:
Accounting Journal is the first step of accounting cycle that records of financial transactions in
order by date according to debit and credit. A journal is a detailed account that records all the
financial transactions of a business, to be used for the future reconciling of accounts and the

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transfer of information to other official accounting records, such as the general ledger. Entering
transaction data in the journal is known as journalizing.
Illustration:

Illustration:

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2.7: Ledger:
A ledger is a book containing accounts in which the classified and summarized information from
the journals is posted as debits and credits. The ledger contains the information that is required to
prepare financial statements. It includes accounts for assets, liabilities, owners' equity, revenues
and expenses. Transferring journal entries to the ledger accounts is called posting.

Illustration:

2.8: Chart of accounts:

The chart of accounts is a listing of all accounts used in the general ledger of an
organization. The chart is used by the accounting software to aggregate information into an
entity's financial statements. The chart is usually sorted in order by account number, to ease
the task of locating specific accounts. The accounts are usually numeric, but can also be
alphabetic or alphanumeric.
Accounts are usually listed in order of their appearance in the financial statements, starting
with the balance sheet and continuing with the income statement. Thus, the chart of
accounts begins with cash, proceeds through liabilities and shareholders' equity, and then
continues with accounts for revenues and then expenses. Many organizations structure th eir
chart of accounts so that expense information is separately compiled by department; thus,
the sales department, engineering department, and accounting department all have the same
set of expense accounts. The exact configuration of the chart of accounts will be based on
the needs of the individual business. Typical accounts found in the chart of accounts are:
a) Assets:
 Cash.
 Petty Cash .
 Marketable Securities .

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 Accounts Receivable .
 Allowance for Doubtful Accounts (contra account).
 Prepaid Expenses .
 Inventory.
 Fixed Assets .
 Accumulated Depreciation (contra account).
 Other Assets .
b) Liabilities:
 Accounts Payable .
 Accrued Liabilities .
 Taxes Payable .
 Wages Payable .
 Notes Payable .
c) Stockholders' Equity:
 Common Stock .
 Preferred Stock .
 Retained Earnings .
d) Revenues:
 Revenue .
 Sales returns and allowances (contra account).


e) Expenses:
 Cost of goods sold.
 Advertising Expense .
 Bank Fees .
 Depreciation Expense .
 Payroll Tax Expense .
 Rent Expense.
 Supplies Expense .
 Utilities Expense .
 Wages Expense .
 Other Expenses.

2.9: Trial balance:

A trial balance is a bookkeeping worksheet in which the balances of all ledgers are compiled into
debit and credit account column totals that are equal. A company prepares a trial balance
periodically, usually at the end of every reporting period.

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Steps of trial balance: The four basic steps to developing a trial balance are:
a) Prepare a worksheet with three columns: One column is for account titles, another is for
debits, and the other is for credits.
b) Fill in all the account titles and record their balances in the appropriate debit or credit
columns.
c) Total the debit and credit columns.
d) Compare the column totals.

Illustration:

2.10: Limitation of trial balance:

Trial balance is prepared to check the arithmetical accuracy of the postings of ledgers. It means
that the trial balance is used to check the party between debit totals and credit totals. If both the
totals are not equal, there must be some shortcomings in the postings made and hence,
rectification must be done. The limitations of trial balance are given below:
a) A transaction is not journalized;

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b) A correct journal entry is not posted;
c) A journal entry is posted twice;
d) Incorrect accounts are used in journalizing or posting; or
e) Offsetting errors are made in recording the amount of a transaction.

2.11: Balance Sheet:

A balance sheet is a financial statement that reports a company's assets, liabilities and
shareholders' equity at a specific point in time, and provides a basis for computing rates of return
and evaluating its capital structure.
A balance sheet is a statement of the financial position of a business that lists the assets,
liabilities, and owner's equity at a particular point in time. In other words, the balance sheet
illustrates your business's net worth.

2.12: Conclusion:
It is very important that business owners make a habit of recording their business transactions
every day. It will assist in making informed, efficient and precise decisions at any time. Well-
kept accounting records act as a reminder of a person's deductible credits and expenses. Proper
bookkeeping involves maintaining up to date accounting system, which includes recording
business transactions as they occur, as well as keeping important receipts or bills for
substantiating all expenses incurred on behalf of the business.

2.13: Demonstration Problem:

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EXERCISE

Excercise-01:
C.R Byrd start a advertisement agency called “Pioneer Advertising Agency” on October 01,
2008. The following transactions occurred during the month of operation:
Oct. 01. C.R. Byrd invests $30,000 cash in the business.
01. Pioneer purchases office equipment costing $5,000 by signing a 3-month, 12%
$5,000 note payable.
02. Pioneer received a $1,200 cash advanced from R. Knox, a client, for advertising service
that are expected to be completed by December 31.
03. Pioneer pays office rent for October in cash, $900.
04. Pioneer pays $600 for a one-year insurance policy that will expire next year on
September 30.
05. Pioneer purchases an estimated 3-month supply of advertising materials on account
from Aero Supply for $2,500.
20. C.R. Byrd withdraws $550 cash for personal use.
26. Pioneer owes employee salaries of $4,000 and pays them in cash.
31. Pioneer receives $10,000 in cash from Copa Company for advertising services provided
in October.

Instructions:
(i) Journalize the September transactions.
(ii) Open ledger accounts and post the September transactions.
(iii) Prepare a trial balance at October 30, 2008.

Exercise-02:
Bob Sample opened the Campus Laundromat on September 1, 2008. During the first month of
operations the following occurred:
Sept 01. Invest $20,000 cash in the business.
02. Paid $1,000 cash for store rent for September.
03. Purchased washers and dryers for $25,000 paying $10,000 in cash and signing a
$15,000, 6-month, 12% note payable.
04. Paid $1,200 for a one-year accident insurance policy.
10. Received a bill from the Daily News for advertising the opening of the Laundromat
$200.
20. Withdrew $700 cash for personal use.
30. Determined that cash receipts for laundry services for the month were $6,200.

Instructions:
(i) Journalize the September transactions.

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(ii) Open ledger accounts and post the September transactions.
(iii) Prepare a trial balance at September 30, 2008.

Exercise-03:
Frontier Park was started on April 1 by C.J. Mendez. The following selected events and
transactions occurred during April.
Apr 01. Mendez invested $40,000 cash in the business.
04. Purchased land costing $30,000 for cash.
08. Incurred advertising expense of $1,800 on account.
11. Paid salaries to employees $1,500.
12. Hired park manager at a salary of $4,000 per month, effective from May 1.
13. Paid $1,500 cash for a one year insurance policy.
17. Withdrew $1,000 cash for personal use.
20. Received $5,700 in cash for admission fees.
25. Sold 100 coupon books for $25 each. Each book contains 10 coupons that entitle the
holder lo one admission to the park. 30 Received $8,900 in cash admission fees.
30. Paid $900 on balance owed for advertising incurred on April.

Instructions:
(i) Journalize the April transactions.
(ii) Post to the ledger accounts.
(iii) Prepare a trial balance at April 30.

Exercise-04:
Jane Kent is a licensed CPA. During the first month of operations of her business, the following
events and transactions occurred.
May 01. Kent invested $25,000 cash.
02. Hired a secretary-receptionist at a salary of $2,000 per month.
03. Purchased $2,500 of supplies on account from Read Supply Company.
07. Paid office rent of $900 cash for the month.
11. Completed a tax assignment and billed client $2,100 for services provided.
12. Received $3,500 advance on a management consulting engagement.
17. Received cash of $1,200 for services completed for H. Arnold Co.
31. Paid secretary receptionist $2,000 salary for the month.
31. Paid 40% of balance June Read Supply Company Jane.

Instructions:
(i) Journalize the transactions.
(ii) Post to the ledger accounts.
(iii) Prepare a trial balance on May 31, 2008.

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Exercise-05:
Rosa Perez is a licensed architect. During the first month of the operation of her business, the
following events and transactions occurred.
April 01. Invest $30,000 cash in the business.
01. Hired a secretary-receptionist at a salary of $500 per week payable monthly
02. Paid office rent for the month $800.
03. Purchased architectural supplies on account from Halo Company $1,500.
10. Completed blueprints on a carport and billed client $1,200 for services.
11. Received $500 cash advance from R. Welk for the design of a new home.
20. Received $1,500 cash for services completed and delivered to P. Donahue.
30. Paid secretary-receptionist for the month $2,000.
30. Paid $600 to Halo Company for accounts payable due.

Instructions:
(i) Journalize the transactions.
(ii) Post to the ledger accounts.
(iii) Prepare a trial balance on April 30, 2008.

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