CHAPTER 4

THE BOOKKEEPING PROCESS AND

TRANSACTION ANALYSIS

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Learning Objectives

1. How can the basic accounting equation be expanded to include revenues and expenses?

2. How does the expanded accounting equation stay in balance after every transaction?

3. How is the income statement linked to the balance sheet through owners’ equity?

4. What are the meanings of the terms journal, ledger, T-account, account balance, debit, credit, and closing the books?

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Learning Objectives

5. How is the bookkeeping system a mechanical adaptation of the expanded accounting equation?

6. How is a transaction analyzed, how is a journal entry prepared, and how is the effect of a transaction on working capital determined?

7. What are the five questions of transaction analysis?

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Learning Objective 1

• How can the basic accounting equation be expanded to include revenues and expenses?

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Bookkeeping/Accounting Process

• The process begins with transactions

• The transactions are reflected in the financial statements

• One must know the mechanical process to understand the effects of transactions on the financial statements

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The Balance Sheet Equations

• The basic equation is: Assets = Liabilities + Owners’ Equity

• Since Owners’ Equity consists of Paid-In Capital and Retained Earnings, the equation can be restated as:

• Assets = Liabilities + (Paid-In Capital + Retained Earnings)

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The Balance Sheet Equations

• Since Retained Earnings is computed as Beginning Retained Earnings plus Revenues and less Expenses, the basic equation can be restated as:

Assets = Liabilities + (Paid-In Capital + Beginning Retained Earnings + Revenues – Expenses)

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Learning Objective 2

• How does the expanded accounting equation stay in balance after every transaction?

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ASSETS LIABILITIES OWNERS' EQUITYAccounts Merchandise Notes Accounts Paid-In Retained

Transaction Cash Receivable Inventory Equipment Payable Payable Capital Earnings Revenue Expenses1. +30 +302. -25 +253. +15 +154. -10 +20 +105. +2 +5 -76. +5 -5

Total 17 0 20 18 15 10 307. Revenues +20 +207. Expenses 20 -12 -128. +3 -3

Total 17 20 8 18 15 13 30 +20 -15+5

EXHIBIT 4-1Transaction Summary

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Learning Objective 3

• How is the income statement linked to the balance sheet through owners’ equity?

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Linking the Income Statement and the Balance Sheet

• The Net Income on the Income Statement gets into the Balance Sheet through the Retained Earnings section of Owners’ Equity

• See the previous slide for an example

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Learning Objective 4

• What are the meanings of the terms journal, ledger, T-account, account balance, debit, credit, and closing the books?

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Bookkeeping Jargon and Procedures

• Journal – where transactions are initially recorded

• Post – to record• Ledger – a set of accounts for each category of

asset, liability, and owners’ equity• Chart of accounts – an index to the ledger• T-Account – an account format that looks like a

“T.” One side indicates an addition; the other a subtraction from the account

• Debit – the left side• Credit – the right side

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Learning Objective 5

• How is the bookkeeping system a mechanical adaptation of the expanded accounting equation?

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The Bookkeeping System

• Debits must always equal credits• Asset accounts will normally have

debit balances• Increases in assets are entered as debits;

decreases are entered as credits• Liabilities and Owners’ Equity are the

opposite of Assets. Debits are decreases and credits are increases

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Journal Entries• The journal is the book of original entry• The format for a journal entry is as follows:

Date Dr. Account name AmountCr. Account name

Amount

• Note the date is entered for reference• Dr. and Cr. are used for debit and credit• A journal entry may have more than one

debit and more than one creditMcGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 6

• How is a transaction analyzed, how is a journal entry prepared, and how is the effect of a transaction on the financial statements determined?

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Transaction Effects - Balance Sheet

• The horizontal model is an alternative to using T-accounts and journal entries

• The model is as follows:

Balance Sheet Income Statement

Assets = Liabilities + Owners’ Equity Net Income = Revenues – Expenses

(Accounts and amounts affected by transactions are entered under the appropriate categories)

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Adjusting Entries

• Made to reflect accrual accounting in the financial statements

• Results in revenues and expenses being reported in the appropriate fiscal period

• Two types of adjusting entries

• Accruals• Reclassifications

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Accruals and Reclassifications

• Accruals- transactions for which cash has not yet been received or paid, but revenues and expenses need to be matched

• Reclassifications – the initial recording of a transaction must be reclassified to reflect when revenues were earned or when expenses were incurred

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Accruals

• Example: Work performed by employees in March, but paid in April

• At the end of March debit Wages Expense and credit Wages Payable

• Example: Interest earned in March, but not received

• At the end of March debit Interest Receivable and credit Interest Revenue

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Reclassifications• Example: Supplies are purchased in February

and are recorded as an asset. Then the supplies are used.

• The expense Supplies Expense should be debited and the asset Supplies should be credited for the amount of supplies used

• If the purchased supplies were debited to Supplies Expense when purchased, the unused supplies should be debited to the asset account and the Supplies Expense account should be creditedMcGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Adjusting Entries Revisited

• Generally, every adjusting entry affects both the Balance Sheet and the Income Statement

• After the adjusting entries have been made, the account balances are determined, and the financial statements are prepared

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Learning Objective 7

• What are the five questions of transaction analysis?

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Five Transaction Analysis Questions

• What’s going on?• What accounts are affected?• How are they affected?• Does the Balance Sheet balance? (Do the debits equal the credits?)• Does my analysis make

sense?

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What’s Going On?

• To analyze a transaction, the transaction must be understood

• It is necessary to understand the entity for which accounting is being done and standard business practices

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What Accounts Are Affected?

• Often the accounts affected are explained by understanding what is going on

• Can also be answered by the process of elimination

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How Are They Affected?

• Answer this by using “increasing” or “decreasing”

• Then relate the increases and decreases to debits and credits to the appropriate accounts

• If using the horizontal model, debits and credits are avoided

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Does the Balance Sheet Balance?

• If using the horizontal model, the answer is found easily

• Remember that debits must equal credits and assets must equal liabilities plus owners’ equity

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Does My Analysis Make Sense?

• Think about the effect of the transaction on the financial statements

• Do the effects that you have recorded reflect what happened?

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