Chapter 4 The Bookkeeping Process and Transaction Analysis

Accounts and Charts of Accounts: Each company collects huge amounts of data, therefore, the company needs a system to accumulate these data. In manual accounting systems, each account is kept in a separate page. The book that contains these pages is called the General Ledger (the same is true for the computerized accounting systems). Chart of accounts: a listing of all the accounts and their codes The Double Entry System: Invented in 1494 by Luca Pacioli The base of all what we do in accounting Based on the principle of duality: that every transaction has to have at least two effects, which offset or balance each other One of the effects need to be a DEBIT, the other need to be a CREDIT so that the dollar values balance with each other The T account: It is the simplest place to start It is formed of three basic parts: 1. Title 2. Debit side (Left side) 3. Credit side (Right Side)

Title of the Account Debit Side Left Side Credit Side Right Side

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

Rules of Double Entry Bookkeeping: 1. Every transaction affects at least two accounts 2. Total debits = Total credits We talked before about the accounting equation: Asssets = Liabilties + Capital + (Revenue - Expenses) And from it we derived the following equation: Asssets + Expenses = Liabilties + Capital + Revenue You could re-read this equation as follows: Assets Resources Owned + Expenses Resources Used = Liability Resources provided through Debt + Capital Resources provided by Owners + Revenues Resources provided by the Firm Credit Beginning Balance Decreases Decreases Increases End Balance

Debit Beginning Balance Increases End Balance

Credit

Debit

Natural balances are Debits

Natural balances are credits

Make sure that you remember that Debits and Credits are the accountants ways of saying left and right and that they do not mean increase and decrease

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

Steps of the Accounting Equation: 1. Event occurs Example 1 Borrow 20000 from the bank Example 2 Buy equipment for 8000 in cash

2. Collect and/or prepare source documents these are the keys that trigger the beginning of the accounting process Example 1 Get the borrowing contract Example 2 Get the invoice for the equipment

3. Analyze the event that occurred this is where you identify what accounts are affected and what the dollar amount is Example 1 Cash increased by 20,000 N/P increased by 20,000 Example 2 Equipment increased by 8,000 Cash decreased by 8,000

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

4. Record the transactions in the general journal The journal is a chronologically ordered accounting book that shows transactions when they happen. I.e. it is recorded based on its date Example 1 Cash is an Asset --- for an Asset to increase we Debit it N/P is a Liability for a Liability to increase ---we Credit it Example 2 Equipment is an Asset --- for an Asset to increase we Debit it Cash is an Asset --- for an Asset to Decrease we Cebit it

Example 1 Debit Jan 15th Cash N/P Loan from XYZ Bank 20,000 20,000 Credit Jan 21st Equipment Cash

Example 2 Debit Credit

8,000 8,000

Purchase of Equipment

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

5. Post transactions to Ledger We basically transfer the amounts to the appropriate accounts The ledger is set by account. Each account has a separate page that shows the beginning balance, increases to the account, decreases of the account and the end balance Cash Debit 20,000 Credit 8,000 Equipment Debit 8,000 Credit Debit N/P Credit 20,000

12,000

8,000 Cash

20,000

Date Jan 15 Jan 21

Description Borrowed Cash from bank Bought Equipment for Cash

Ref.

Dr. 20,000

Cr.

Balance Dr. 20,000 Cr.

8,000 Equipment

12,000

Balance Date Jan 21 Description Bought Equipment for Cash Ref. Dr. 8,000 Cr. Dr. 8,000 Cr.

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

N/P Date Jan 15 Description Borrowed Cash from bank Ref. Dr. Cr. 20,000 Balance Dr. Cr. 20,000

6. Prepare Trial Balance A Trial Balance in a list of all accounts in the accounting system with their ending balances It is a periodical statement that is based on the equality of debits and credits For each debit there is an equal and opposite credit The Trial Balance can be prepared at any time, but its usually prepared at the end of each month Account Cash Equipment N/P Totals Remember the accounting equation: Assets + Expenses + Withdrawals All accounts on this side are increased with debits and decreased with credits Liabilities + Investments + Revenues All accounts on this side are decreased with debits and increased with credits 20,000 Debit 12,000 8,000 20,000 20,000 Credit

The Trial Balance can tell us whether Debits equal Credits. However, the Trial Balance cannot tell us if: 1. The transactions are described correctly: you can debit and credit but the problem is that you can debit and credit the wrong accounts. As a result, the trial; balance will balance but the individual accounts will be wrong. 6

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

2.

There are omitted transactions

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

In Class Exercise (1) For each of the following transactions indicate: 1. What accounts are affected 2. How are they affected (increased or decreased) 3. Whether it is debited or credited, and by what amount Description 1 Borrowed 20,000 Cash from a bank Purchased Equipment for 50,000 in Cash Bought 1,000 worth of inventory on Credit Sold inventory costing 300 for 500 in Cash Account Cash N/P Amount 20,000 20,000 Increased / Decreased Increased Increased Debit 20,000 20,000 Credit

2 3 4

5 6

Paid employees their wages of 200 Sold inventory costing 550 for 700 on Credit

Collected the 700 from the previous step

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

Matching Issues
Cash Basis Accounting: The important part is the Cash transactions This method recognizes events in the accounting system on the basis of a cash exchange with another party. This could be cash received from investors (creditors or owners), or cash received from customers for sales. Because the use of credit for purchases/sales, & because not all costs are paid when incurred (wages, utilities), there is frequently a difference in timing between when a resource is consumed/acquired and when cash is consumed/acquired. Under the Cash Basis Accounting, Revenues and Expenses are recorded when cash is received or paid . The problem is that cash paid to buy inventory may be paid in a different period than when the inventory is sold, and cash is collected from the sale As a result, the revenue and expense of the same transaction may be recorded at different periods The Matching rule Revenue must be assigned to the accounting period in which the goods are sold or the services are performed Expenses must be assigned to the accounting period in which they produce the revenue. Accrual Basis of Accounting: Aims to record the financial transactions of a company in the period when they occur rather than when cash exchanges hands. Accrual basis of accounting measurement: measures and records transactions at the time resources are acquired, sold or consumed, regardless of whether cash has changed hands yet. This means that we : Recognize revenue when earned (e.g. sale is made or service is rendered) Recognize expense when incurred (e,g, asset is used or sold) Accrual accounting also results in adjustment to keep the accounting books up to date Adjusting entries are entries that accountants use to apply accrual accounting transaction that span more than one period Adjusting entries never effect the cash account

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

CASH vs. ACCRUAL Event Cash Sale Cash Accounting Cash Sales Nothing Increase Increase Accrual Accounting Cash Increase Sales Increase Inventory Decrease COGS Increase Accounts Receivable Increase Sales Increase Inventory Decrease COGS Increase Cash Accounts Receivable Wages Payable Wages Expense Wages Payable Cash Interest Payable Interest Expense Interest Payable Cash Cash Asset Depreciation Expense Accumulated Depreciation (Asset Decreases) Increase Decrease Increase Increase Decrease Decrease Increase Increase Decrease Decrease Decrease Increase Increase Increase

Credit Sale

Cash Collected Wages Accrued Wages Paid Interest Accrued Interest Paid Asset Bought

Cash Sales Nothing Cash Wage Expense Nothing Cash Interest Expense Cash Asset Nothing

Increase Increase

Decrease Increase

Decrease Increase Decrease Increase

Depreciation: is the systematic allocation of the cost of an asset over the economic useful life of this asset. It is very important to note that it is not a cash item but it is an allocation of cost. As indicated by the accrual accounting methods there are timing differences between the time when revenues and expenses are recorded for an item and when the related cash is received or paid There are two types of differences: 10

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

Deferrals: Cash received and paid before revenues and expenses are recorded Accruals: Cash received and paid after revenues and expenses are recorded 1. Deferred Expenses: Cash is recorded before related expense is recorded

Prepaid Expenses These are expenses that are paid in advance (e.g. rent, insurance etc.) E.g. You pay $3,000 for 3 months rent in advance When cash is paid Dr. Prepaid Rent 3,000 Cr. Cash 3,000 At the end of the 1st month (This is called an adjusting entry) Dr. Rent Expense 1,000 Cr. Prepaid Rent 1,000 Prepaid Rent 3,000 1,000 2,000 Rent Expense 1,000 1,000

Depreciation: We allocate the cost of long term assets over more than one period The useful life of the asset is estimated If you Buy a machine for $10,000 in cash that you estimate its useful life to be 10 years Depreciation per year = 10,000/10 = 1,000 per year When the machine is bought Dr. Machine Cr. Cash 10,000 10,000

At the end of the 1st year (adjusting entry) Dr. Depreciation Expense 1,000 Cr. Accumulated Depreciation 1,000

Note that we did not credit (decrease) the asset account directly but instead we credited an account that is called Accumulated Depreciation. This account is a contra asset account 11

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

 A Contra Asset is an account that is related and opposite to another account It is shown as a deduction from the related account (Asset account) We use Contra Asset accounts instead of the deduction from the Asset account to show that it is an estimate and to show the actual cost of the Asset. 2. Accrued Expense: Expenses are recorded before the related cash is paid Wages of $5,000 are accrued and owed to the employees for their work during January (but not yet paid) and will be paid in February. When the wages are accrued Dr. Wages Expense Cr. Wages Payable 5,000 5,000

When the wages are paid ( adjusting entry) Dr. Wages Payable 5,000 Cr. Cash 5,000 Wages Payable 5,000 5,000 0 Wages Expense 5,000 5,000

3.

Deferred Revenue: When we receive cash before the related revenue is earned

Unearned Revenue ( Liability) Cash that is received in advance before the related revenue is earned A publishing company received $6,000 in advance to cover the subscriptions for the magazine for the next 3 month When the cash is received Dr. Cash 6,000 Cr. Unearned revenue 6,000 At the end of the 1st month (adjusting entry) Dr. Unearned Revenue 2,000 Cr, Revenue 2,000 12

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

Unearned Revenue 2,000 6,000 4,000

Revenue 2,000 2,000

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

4.

Accrued Revenue: Revenue that is recorded before the collection of related cash

Credit sales The company sold $30,000 worth of goods for $50,000 on credit When the sale is made Dr. Accounts Receivable Cr. Revenue When cash is received Dr. Cash 50,000 Cr. Accounts Receivable 50,000 50,000 50,000

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

In Class Exercise (2) Perfect Clean Cleaning Company had the following transactions during July of 2008: 1. The owners invested additional $10,000 in the business. 2. The company sold detergents for $20,000 on credit in July and billed the customers (they did not collect any of this amount). 3. The cost of the detergents that were sold during July are $16,000. These detergents were bought in April. 4. The company paid $3,000 for the utility bill of June. 5. They collected $15,000 from customers for services rendered during June. 6. The executive director was paid $9,000 for his salary for May, June, and July 7. Detergents totaling $5,000 were sold for customers who had previously paid for them in June 8. The company bought a new machine for $30,000 in cash Required: Complete the following table for the above transactions for the month of July. What would the results of operations be under (1) Accrual and (2) Cash flow accounting? Effect on Income Statement 1. 2. 3. 4. 5. 6. 7. 8. *** Effect on Cash Flow (+) 10,000

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

In Class Exercise (3) George borrowed $300,000 on January 1, 2008 to start a computer software company. Annual interest on the loan is $12,000. Complete the following table using the related assumptions. Assume that each situation is independent from he other. a. The interest payments will be made at the end of each quarter. The first payment will be paid on March 31st January Interest Expense Interest Paid (cash) February March Quarter Total

b. The interest payments will be made at the end of each month. The first payment will be paid on January 31st January Interest Expense Interest Paid (cash) February March Quarter Total

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis

In Class Exercise (4) North Fork Operations began operations on January 1, 2008. The following events occurred during 2008: The Company issued $4,500,000 of Stock to investors and $3,000,000 of Long Term Debt The Company bought Land and Machines for $7,200,000 in cash The Company performed services wroth $2,550,000. Customers paid $2,100,000 and the Company was owed $450,000 for services provided during the period. The Company paid $1,500,000 for Wages, Interest, and Operating activities for resources consumed during 2008 1. What was North Fork's Net Cash Flow from Financing, Investing, and Operating activities for 2008? And what was the total Cash Flow for the period?

2. Prepare an Accrual basis Income Statement for North Fork's first year (2008) in business.

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Dr. Khaled Dahawy Ch 4: The Bookkeeping Process & Transaction Analysis