CHAPTER 2 FUNDAMENTAL ACCOUNTING PRINCIPLES, VOLUME 1 PDF

Page 91 CHAPTER 2 Analyzing and Recording Transactions A Look Back Chapter 1 defined accounting and introduced financial statements. We described forms of organizations and identified users and uses of accounting. We defined the accounting equation and applied it to transaction analysis. A Lo...

Page 91 CHAPTER 2 Analyzing and Recording Transactions A Look Back Chapter 1 defined accounting and introduced financial statements. We described forms of organizations and identified users and uses of accounting. We defined the accounting equation and applied it to transaction analysis. A Look at This Chapter This chapter focuses on the accounting process. We describe transactions and source documents, and we explain the analysis and recording of transactions. The accounting equation, T-account, general ledger, trial balance, and debits and credits are key tools in the accounting process.  Courtesy of Monoxide Style and designer Tyler Ferguson LEARNING OBJECTIVES LO1 Explain the accounting cycle. LO2 Describe an account, its use, and its relationship to the ledger. LO3 Define debits and credits and explain their role in double-entry accounting. LO4 Describe a chart of accounts and its relationship to the ledger. LO5 Analyze the impact of transactions on accounts, record transactions in a journal, and post entries to a ledger. LO6 Prepare and explain the use of a trial balance. Page 92 Accounting Is So Important! At the young age of 18, Tyler Ferguson began developing her own luxury jewellery line—MONOXIDE. Through her incredible talent, she aims to “tell tales of authenticity, translating genuine stories through the creation of visual pieces.” Tyler was born in Toronto and was raised in both Canada and the Bahamas. She was exposed to the wholesale jewellery business through her teen years and her family ran a retail business as she grew up. It was from one impactful experience she had when she decided to take on the job of repairing a piece of jewellery that her passion for jewellery design was ignited. Tyler came up with the name MONOXIDE as it represents the brand’s balance between hardness and softness. “When you break it down, mono means ‘one’ and oxide means ‘breath.’ The name is hard but with a soft meaning and this one word I feel perfectly encapsulates my brand, which is bold yet modern and perfect for any occasion and portrays an emotion with the simple act of choosing to put a bit of luxury in your everyday.” According to Tyler, “MONOXIDE is about being who you want to be, not who you should be.” Her goal is to create an environment where individuals feel free to express their authenticity. Tyler custom makes every single item that is sold under her brand through both reclaimed and vintage jewellery that she combines with different semi-precious stones and various materials to create one-of-a-kind pieces and short-run collections. She is a true artisan with an amazing ability to combine textures, gemstones, and fine metals to produce unique pieces for both men and women. She maintains a very small inventory of her product line, and as she notices styles change she is able to pivot and reinvent the design of older products that she has not yet sold to create something current and unique. Tyler emphasizes clearly that “accounting is so important” and that the number one thing you need to do as an entrepreneur is to “keep on top of your financials.” At the beginning of her journey at the age of 18, when she started selling her jewellery, she had no prior experience with managing the financial side of her business. She began to realize that if she was going run a successful business understanding her cost per item was critical to enable her to price products effectively at the retail and wholesale level. She also values the ability to track the year-over-year growth of her business so she is able to debrief and understand which products are performing best and give her the highest return. She really appreciates the value in a summary spreadsheet and has found Microsoft Excel to be an efficient and effective tool to track both her total costs and her total sales. Tyler uses Squarespace to design and run her website. Squarespace provides access to data analytics, relating information on where website traffic is coming from, what visitors are looking for, and how users are interacting with Web content. This information is very useful to Tyler, who can then make effective marketing and product design decisions based on targeting customer demands. Squarespace also provides Tyler with information on tracking revenue, orders, units sold, and which products are generating the most sales. She does most of her marketing through social media, particularly on @monoxidestyle, her Instagram account, which enables her to direct sales to her website through links to products that are featured. Tyler’s vision for the future of MONOXIDE is to continue to expand the brand both nationally and internationally and to continue to do branded collaborations through creating capsule collections for other well-known brands and popular influencers. Sources: Interview with Tyler Ferguson, September 28, 2020; www.monoxidestyle.com; www.squarespace.com. CRITICAL THINKING CHALLENGE What does Tyler Ferguson mean when she says that the number one thing you need to do as an entrepreneur is to keep on top of your financials? Answer Accounting information results in the ability to make effective day to day business decisions. Understanding cash flow and tracking revenue helps Tyler to invest in creating the right products to meet customer demands. It also helps Tyler to understand profitability and how to best invest her marketing dollars to sell the most profitable products. CHAPTER PREVIEW The accounting process identifies business transactions and events, analyzes and records their effects, and summarizes and presents information in reports and financial statements. These reports and statements are used for making investing, lending, and other business decisions. The steps in the accounting process that focus on analyzing and recording transactions and events are shown in Exhibit 2.1. Page 93 EXHIBIT 2.1 Accounting Cycle Business transactions and events are the starting points as inputs into the accounting system. The transactions and events are analyzed using the accounting equation to understand how they affect company performance and financial position. These effects are recorded in accounting records using the related source documents, such as sales invoices and purchase invoices. Additional steps such as posting and then preparing a trial balance help summarize and classify the effects of transactions and events. Ultimately, the accounting process provides information in useful reports or financial statements to decision makers. Student success in mastering this cycle requires commitment to read the material, do the exercises, check the appropriate answers, and apply critical thinking skills in analyzing conclusions. The Accounting Cycle LO1 Explain the accounting cycle. The accounting cycle refers to the series of steps required to prepare a Page 94 set of financial statements for users. These steps are referred to as a cycle because they are repeated each time financial statements are prepared for that company, also known as a reporting period. Exhibit 2.1 illustrates the required steps in the accounting cycle. Chapter 1 introduced transaction analysis, the first step in the accounting cycle. Chapter 2 will focus on the next three steps of the accounting cycle. Step 7, the preparation of financial statements, was introduced in Chapter 1 and is reinforced in Chapters 2 through 4. Accounts LO2 Describe an account, its use, and its relationship to the ledger. This section explains the importance of an account to accounting and business. We also describe several crucial elements of an accounting system, including ledgers, T-accounts, debits and credits, double-entry accounting, and the chart of accounts. THE ACCOUNT An account is a detailed record of increases and decreases in a specific asset, liability, or equity item. Information is taken from accounts, analyzed, summarized, and presented in useful reports and financial statements for users. Separate accounts1 are kept for each type of asset, liability, and equity item. Ex hibit 2.2 shows examples of the different types of accounts used by Organico. EXHIBIT 2.2 Types of Accounts for Organico General ledger is the term used to describe a record containing all individual accounts used by a business. A ledger is typically maintained electronically and provides detailed information regarding each financial transaction that is recorded over the life of the business. Each company will have its own unique set of accounts to suit its type of operation. The following section introduces accounts that are most commonly used by businesses today. ASSET ACCOUNTS Assets are properties or economic resources held by a business with three key attributes: 1. The transaction to acquire the asset has occurred. 2. The company has control over the asset (owns/has title to the asset). 3. A future benefit exists for the company as it is used in operations.2 Assets have value and are used in the operations of the business to create Page 95 revenue. For example, airplanes are assets held by WestJet for the purpose of creating revenue in current and future periods. Accounting standards require that a separate account is maintained for each asset category. Important Tip: Identifying Asset Accounts Asset accounts are often intuitive in nature. For example, cash, supplies, inventory, land (property), buildings, and equipment all are examples of assets. Two other key words to watch for are “receivables” and “prepaids.” A receivable is an asset because the company has the legal right to collect the outstanding balance. Prepaids indicate the company has paid in advance for a service or goods and will benefit from this in the future. Assets have a debit balance. Cash increases and decreases are recorded in a separate Cash account. Examples are coins, currency, cheques, money orders, and savings account and chequing account balances. Each bank account used by the company will have a separate account number. Receivables are amounts that the business is expecting to receive or collect in the future. Types of receivables include: Accounts receivable are an asset that is created when services are performed for or goods are sold to customers. The amount recorded as a receivable reflects a commitment from the customer to pay in the future, instead of settling in cash today. These transactions are said to be on credit or on account. Accounts receivable are increased as services are performed or goods are sold on credit and decreased when customers make payments.  Notes receivable (or promissory notes) are a formal contract signed by the customer or another party that owes a specific sum of money to the company. The contract provides details regarding the total dollar value of the commitment, when the payment is due, and any interest required to be paid. Prepaid expenses occur when a company pays in advance for a service or goods for which the benefit extends beyond the current accounting period. Examples include Office Supplies, Prepaid Rent, and Prepaid Insurance. As these assets are used up, the costs of the used assets become expenses. This account supports the matching principle introduced in Chapter 1. Because the benefits of these goods/services are used in future periods, they should be matched to the revenue in future periods. A prepaid cost can be initially recorded as an expense if it is used up before the end of the period. Equipment includes assets such as vehicles, machinery, computers, printers, desks, chairs, display cases, and cash registers. These assets are used in the operations of a business for more than one accounting period. Buildings are assets owned by an organization that can provide space for a store, an office, a warehouse, or a factory. The benefits of buildings purchased by the company generally extend many years into the future. Land owned by a business is shown as an asset. The cost of land is separated from the cost of buildings located on the land to provide more useful information in financial statements. The value of land typically does not diminish over time. Page 96 LIABILITY ACCOUNTS Liabilities are obligations of the business that have two key attributes: 1. They are a present obligation as a result of a past event 2. The company has an outstanding obligation to pay via a transfer of assets or provision of services in the future3 An organization often has several different liabilities, each of which is represented by a separate account that shows amounts owed to each creditor. The more common liability accounts are described here.  Important Tip: Identifying Liability Accounts Two words almost always identify liability accounts: “payable” and “unearned.” Payable indicates the liability must be paid, and unearned indicates the liability must be fulfilled through execution of the terms of a contract. Liabilities have a credit balance. Payables are promises by a business to pay later for an asset or service already received. Types of payables include: Accounts payable occur with the purchase of merchandise, supplies, equipment, or services made with a commitment to pay later Notes payable occur when an organization formally recognizes a promise to pay by signing a contract referred to as a promissory note Unearned revenues result when customers pay in advance for products or services. Because cash from these transactions is received before revenues are earned, the seller considers them unearned, as they do not meet the requirements of the revenue recognition principle introduced in Chapter 1. Unearned revenue is a liability because a service or product is owed to a customer. It will be earned when the service or product is delivered in the future. Examples of unearned revenue include magazine subscriptions collected in advance by a publisher, sales of gift certificates by stores, airline tickets sold in advance, and rent collected in advance by a landlord. Important Tip: Unearned Revenue Is Not Yet Revenue Unearned revenue is not a revenue account but is recorded as a liability. It occurs when cash has already been received by the company for work that has not yet been performed or goods not yet delivered. This account appears as a current liability on the balance sheet, as an obligation exists to perform the service or provide the goods.  Transat A.T. Inc., the company that owns the airline fleet Air Transat, reported unearned revenue in the form of advanced ticket sales in the amount of $608,890,000 on October 31, 2020. Other liabilities include wages payable, taxes payable, and interest Page 97 payable. Each of these is often recorded in a separate liability account. If they are not large in amount, two or more of them may be added and reported as a single amount on the balance sheet. The liabilities section of Recipe Unlimited Corporation’s balance sheet at December 27, 2020, included accounts payable and accrued liabilities of $137,957,000. See Appendix III. DECISION INSIGHT Unearned Revenue  THE CANADIAN PRESS/Frank Gunn Many professional sports teams have over $100 million in advance ticket sales in Unearned Revenue. When a team plays its home games, it settles this liability to its ticket holders and then transfers the amount earned to Ticket Revenue. Teams such as the Toronto Raptors, Montreal Canadiens, Edmonton Oilers, Vancouver Canucks, and Calgary Flames have unearned revenue. NEED-TO-KNOW 2-1 Classifying Accounts LO2 Classify each of the following accounts as either an asset (A), liability (L), or equity (EQ) account. 1. Prepaid Rent 2. Owner, Capital 3. Note Receivable 4. Accounts Payable 5. Accounts Receivable 6. Equipment 7. Interest Payable 8. Unearned Revenue 9. Land 10. Prepaid Insurance 11. Wages Payable 12. Rent Payable Solution 1. A 2. EQ 3. A 4. L 5. A 6. A 7. L 8. L 9. A 10. A 11. L 12. L  Do More: QS 2-1 EQUITY ACCOUNTS We described in the previous chapter four types of transactions that affect equity: (1) investments by the owner, (2) withdrawals by the owner, (3) revenues, and (4) expenses. In Chapter 1, we entered all equity transactions in a single column under the owner’s name, as copied in Exhibit 2.3. When we later prepared the income statement and the statement of changes in equity, we had to review the items in that column to classify them properly in financial statements. EXHIBIT 2.3 Equity Transactions as Analyzed in Chapter 1 Equity Explanation Hailey Walker, Capital $ 10,000 Investment by Owner $ 10,000 $ 10,000 + 2,200 Food Services Revenue $ 12,200 – 1,000 Rent Expense $ 11,200 – 700 Salaries Expense $ 10,500 + 1,600 Food Services Revenue + 300 Teaching Revenue $ 12,400 $ 12,400 $ 12,400  Equity Explanation – 600 Withdrawal by Owner $ 11,800 A preferred approach is to use separate accounts, as illustrated under the Page 98 Equity heading in Exhibit 2.2. Owner Capital records owner investments. The capital account is identified by including the owner’s name. The owner’s capital account includes transactions in addition to owner investments, as discussed in the following two paragraphs. Owner withdrawals are recorded in an account with the name of the owner and the word Withdrawals. This account is also sometimes called the owner’s Personal account or Drawing account. Revenues and expenses incurred for a period are key information required by decision makers. Businesses use a variety of accounts to report revenues earned and expenses incurred on the income statement. Examples of revenue accounts are Sales, Commissions, Consulting Revenue, Rent Revenue, Subscription Revenue, and Interest Income. Recipe Unlimited Corporation uses the simple term Sales to report its direct sales of prepared food and beverages to customers at company- owned restaurants. It also includes sales from its catering division, and sales of St- Hubert and The Keg branded products. Recipe Unlimited Corporation also reports franchise revenues collected from licensing agreements to independent operators of their restaurants (franchisees). Indigo Books & Music Inc. reported $958 million in revenue and $554 million in cost of sales on its March 28, 2020, financial statements (see Appendix III). Examples of expense accounts include Advertising Expense, Store Supplies Expense, Office Salaries Expense, Office Supplies Expense, Rent Expense, Utilities Expense, and Insurance Expense. Important Tip: Use Appendix IV to Help Learn Common Accounts Turn to Appendix IV to find detailed information relating to accounts used within the book. It will help you tremendously to study this appendix  to familiarize yourself with common account names and the categories of accounts they fall under. For example, terminology is listed for several types of expense accounts. The accounts listed will be needed to solve some of the exercises and problems in this book.4 CHECKPOINT 1. Explain the accounting cycle. 2. Classify the following accounts as either assets, liabilities, or equity: (1) Prepaid Rent, (2) Rent Expense, (3) Unearned Rent, (4) Rent Revenue, (5) Buildings, (6) Owner Capital, (7) Wages Payable, (8) Wages Expense, (9) Office Supplies, and (10) Owner Withdrawals. 3. What is the difference among the accounts Rent Earned, Rent Revenue, and Earned Rent? Do Quick Study question: QS 2-1 Page 99 T-ACCOUNTS A T-account is a helpful learning tool that represents an account in the ledger. It shows the effects of individual transactions on specific accounts. The T-account is so named because it looks like the letter T. It is shown in Exhibit 2.4. EXHIBIT 2.4 The T-Account Account Title (Left side) (Right side) Debit Credit The format of a T-account includes (1) the account title on top, (2) a left or debit side, and (3) a right or credit side. Debits and credits are explained in the next section. A T-account provides one side for recording increases in the item and the other side for decreases. As an example, the T-account for Organico’s Cash account after recording the transactions in Chapter 1 is in Exhibit 2.5. EXHIBIT 2.5 Calculating the Balance of a T-Account Cash Investment by owner 10,000 2,500 Purchase of supplies Received from providing food services 2,200 1,000 Payment of rent Collection of account receivable 1,900 700 Payment of salary 900 Payment of account payable 600 Withdrawal by owner Total increases 14,100 5,700 Total decreases Less decreases –5,700 Balance 8,400 T-accounts are used throughout this text to help illustrate debits and credits and to solve accounting problems. This form of account is a learning tool and is typically not used in actual accounting systems. However, many professional accountants often find T-accounts useful for analytical purposes. BALANCE OF AN ACCOUNT An account balance is the difference between the increases and decreases recorded in an account. To determine the balance, we: 1. Calculate the total increases shown on one side (including the beginning balance) 2. Calculate the total decreases shown on the other side 3. Subtract the sum of the decreases from the sum of the increases, and 4. Calculate the account balance. The total increases in Organico’s Cash account are $14,100, the total decreases are $5,700, and the account balance is $8,400. The T-account in Exhibit 2.5 shows how we calculate the $8,400 balance. Page 100 DEBITS AND CREDITS LO3 Define debits and credits and explain their role in double- entry accounting. The left side of a T-account is always called the debit side, often abbreviated Dr. The right side is always called the credit side, abbreviated Cr.5 We enter amounts on the left side of an account to debit the account. We enter amounts on the right side of the T-account to credit the account. The difference between total debits and total credits for an account is the account balance. When the sum of debits exceeds the sum of credits, the account has a debit balance as is demonstrated with the following example: Office Supplies 100 60 300 200 Balance 140 Total debits = 100 + 300 = 400 Total credits = 60 + 200 = 260 Balance = 400 – 260 = $140 debit balance A T-account has a credit balance when the sum of credits exceeds the sum of debits, as is illustrated next: Accounts Payable 350 400 500 600 150 Balance Total debits = 350 + 500 = 850 Total credits = 400 + 600 = 1,000; Credits are greater than debits, so the Balance = 850 – 1,000 = $150 credit balance When the sum of debits equals the sum of credits, the account has a zero balance. This dual method of recording transactions as debits and credits is an essential feature of double-entry accounting, and is the topic of the next section. DOUBLE-ENTRY ACCOUNTING Double-entry accounting means every transaction affects and is recorded in at least two accounts. For the accounting records to be accurate, every time a transaction is recorded the total amount debited must equal the total amount credited. For example, if a clothing business pays $1,000 cash for custom T-shirts they intend to resell, the asset inventory is debited by $1,000 and the cash account is credited by $1,000. If multiple accounts are impacted by a particular transaction, the sum of the debits recorded must equal the sum of the credits for each economic event captured in the accounting records. As well, the sum of all debit account balances in the ledger must equal the sum of all credit account balances in the ledger. Double-entry accounting helps to prevent errors by ensuring that debits and credits for each transaction are equal. Debits = Credits Important Tip: Identifying an Error in Recording a Transaction In recording a single accounting transaction, as well as in a detailed system of accounts (referred to as a ledger) and also in a trial balance (summary of ending balance for each account in the ledger), the only reason that the sum of debit balances would not equal the sum of credit balances is if an error had occurred. The system for recording debits and credits follows from the accounting equation in Exhibit 2.6. EXHIBIT 2.6  Accounting Equation Assets are on the left side of this equation. Liabilities and equity are on Page 101 the right side. Like any mathematical equation, increases or decreases on one side have equal effects on the other side. For example, the net increase in assets must be accompanied by an identical net increase in the liabilities and equity side. Some transactions affect only one side of the equation. This means that two or more accounts on one side are affected, but their net effect on this one side is zero. The debit and credit effects for asset, liability, and equity accounts are captured in Exhibit 2.7. EXHIBIT 2.7 Debit and Credit Effects for Accounts Important Tip: Memorize Your Accounting Rules Ensure you know the following rules as illustrated in Exhibit 2.7 before reading Chapter 3. For a helpful learning tool, review the video “Debit Credit Theory (Accounting Rap Song)” on YouTube by Colin Dodds, an educational music video enthusiast. Video Link: https://youtu.be/j71Kmxv7smk Three important rules for recording transactions in a double-entry accounting system follow from Exhibit 2.7.  1. Increases in assets are debited to asset accounts. Decreases in assets are credited to asset accounts. 2. Increases in liabilities are credited to liability accounts. Decreases in liabilities are debited to liability accounts. 3. Increases in equity are credited to equity accounts. Decreases in equity are debited to equity accounts. CAUTION: Do not assume the terms debit and credit mean increase or decrease. For asset accounts debit means increase and credit means decrease. When liabilities and equity are increased the related account is credited and when they are decreased the related account is debited. We explained in Chapter 1 how equity increases with owner Page 102 investments and revenues, and decreases with expenses and owner withdrawals. Please note that revenues and expenses impact equity through the profit (loss) recognized on the income statement. The equity adjustment of recording the profit (loss) to the owner’s capital account is not made until after the financial statements have been prepared. The closing process is covered in Cha pter 4 (refer to Exhibit 4.5 outlining the recording and posting of closing entries). We can therefore expand the accounting equation and debit and credit effects as shown in Exhibit 2.8 and summarize them in Exhibit 2.9. EXHIBIT 2.8 Debit and Credit Effects for Accounts EXHIBIT 2.9 The Debit and Credit Summary Debit and Credit Summary Debits Record Credits Record Assets Liabilities Expenses/Losses Revenues/Profit Withdrawals Owner’s Capital ⟹ Investments Debits Decrease: Credits Decrease: Existing Liabilities Existing Assets  Important Tip: When to Adjust Owner’s Capital Account to Reflect Profit/Loss Profit (loss) is booked by a journal entry to the Owner’s Capital account only after financial statements have been prepared, during the closing process discussed in Chapter 4. Profit is added manually to equity in the statement of changes in owner’s equity, as is shown in the end- of-chapter Demonstration Problem featuring The Cutlery. In preparing financial statements it is therefore important to start with the income statement, and then prepare the statement of changes in equity, and then finally the balance sheet. As a result, equity, as presented on the balance sheet, reflects the profit for the current year. Exhibit 2.10 highlights the normal balance of each type of account.6 Page 103 The normal balance refers to the debit or credit side when increases are recorded and in most cases where the balance in the account should rest. For example, the normal balance for an asset account would be a debit because a debit balance indicates that the company has something that will provide a future benefit. The normal balance for a revenue account would be a credit because revenues are increased by credits and result in an increase in equity. EXHIBIT 2.10 Normal Account Balances Normal Account Balances Debit Credit Assets Liabilities Withdrawals Owner’s Capital* Expenses Revenue *Used to record owner investments profit closing entry after f/s preparation. Important Tip:  The video “Trick to Remember Debits and Credits”* on the StudentsKnow YouTube channel highlights a “Hand Game,” presenting a quick way to remember your debits and credits. Video Link: https://www.youtube.com/watch?v=onq8AfjxjRo *Thanks to Leanne Vig, MBA, CGA, Accounting Instructor, Red Deer College for sharing this helpful learning tool. Increases in owner’s capital or revenues increase equity. Increases in owner’s withdrawals or expenses decrease equity. These important relations are reflected in the following four additional rules: 4. Investments in the company made by the owner are credited to owner’s capital because they increase equity. 5. Revenues are credited to revenue accounts because they increase equity, as they increase profit. 6. Expenses are debited to expense accounts because they decrease equity, as they decrease profit. 7. Withdrawals made by the owner are debited to owner’s withdrawals because they decrease equity. Our understanding of these diagrams and rules is crucial to analyzing and recording transactions. This also helps us to prepare and analyze financial statements.7 Page 104 NEED-TO-KNOW 2-2 Normal Account Balance LO3 Identify the normal balance (debit [Dr] or credit [Cr]) for each of the following accounts. 1. Prepaid Rent 2. Owner, Capital  3. Note Receivable 4. Accounts Payable 5. Accounts Receivable 6. Equipment 7. Interest Payable 8. Unearned Revenue 9. Land 10. Prepaid Insurance 11. Owner, Withdrawals 12. Utilities Expense Solution 1. Dr. 2. Cr. 3. Dr. 4. Cr. 5. Dr. 6. Dr. 7. Cr. 8. Cr. 9. Dr. 10. Dr. 11. Dr. 12. Dr. Do More: QS 2-2, QS 2-3, QS 2-4, E 2-1 CHART OF ACCOUNTS LO4 Describe a chart of accounts and its relationship to the ledger. Recall that the collection of all accounts in a company’s accounting information system is called a ledger. The number of accounts needed in the ledger is affected by a company’s size and diversity of operations. A small company may have as few as 20 accounts, while a large company may need several thousand. The chart of accounts is a list of all accounts used in the ledger by a company. The chart includes an identification number assigned to each account. The chart of accounts in Appendix IV of the text uses the following numbering system for its accounts:  101–199 → Asset accounts 201–299 → Liability accounts 301–399 → Owner capital and withdrawals accounts 401–499 → Revenue accounts 501–599 → Cost of sales expense accounts 601–699 → Operating expense accounts The numbers provide a three-digit code that is useful in recordkeeping. In Page 105 this case, the first digit assigned to asset accounts is 1, while the first digit assigned to liability accounts is 2, and so on. The first digit of an account’s number also shows whether the account appears on the balance sheet or the income statement. The second and subsequent digits may also relate to the accounts’ categories. The numerical basis of a chart of accounts is a fundamental component of a computerized accounting system. A partial chart of accounts for Organico follows. 8 Account Number Account Name 101 Cash 106 Accounts Receivable 125 Supplies 128 Prepaid Insurance 167 Equipment 201 Accounts Payable 236 Unearned Teaching Revenue 240 Notes Payable 301 Hailey Walker, Capital 302 Hailey Walker, Withdrawals 403 Food Services Revenue 406 Teaching Revenue  Account Number Account Name 622 Salaries Expense 641 Rent Expense 690 Utilities Expense CHECKPOINT 4. What is the relationship of an account to the ledger and chart of accounts? 5. What is the normal balance for assets, liabilities, revenue, expenses, withdrawals, and capital accounts? Do Quick Study questions: QS 2-2, QS 2- 3, QS 2-4, QS 2-5 DECISION INSIGHT Recipe Unlimited Corporation owns several popular Canadian restaurant brands including Swiss Chalet, Harvey’s, Montana’s, and Milestones. Its income statement for the year ended December 27, 2020 showed total revenues of $865 million. On the December 27, 2020 balance sheet, there were total assets of $2.1 billion, total liabilities of $1.8 billion, and total equity of $284 million. Although the details of Recipe Unlimited Corporation’s chart of accounts cannot be seen on its financial statements, it likely has hundreds of accounts to track its wide range of transactions. Refer to Appendix III, Recipe Unlimited Corporation Annual Report, December 27, 2020 Recording and Posting Transactions LO5 Analyze the impact of transactions on accounts, record transactions in a journal, and post entries to a ledger. We next walk you through the first four big-picture steps of the accounting cycle: analyzing transactions, journalizing, posting, and preparing an unadjusted trial balance. The first four steps of the accounting cycle are illustrated in Exhibit 2.11. EXHIBIT 2.11 Four Big-Picture Steps of the Accounting Cycle Page 106 The first step in the accounting cycle is identifying a business transaction, as was highlighted in the Chapter 1 discussion of transaction analysis. The second step of recording the journal entry is covered in the next section. We first introduce you to the concept of a journal entry and then demonstrate how a journal entry is recorded using proper presentation. The third step of posting an entry to the ledger is illustrated through examining six key components of a posted journal entry. The chapter demonstrates how the entry is recorded in the general journal and how it is then broken up into the individual ledger accounts. We have broken steps two and three into six micro steps, which are illustrated in detail with Organico’s first 15 transactions later in the chapter. Step four of the accounting cycle, preparing a trial balance, is explained later in the chapter. JOURNAL ENTRY ANALYSIS A journal is a record where journal entries are posted in chronological order. Recording all journal entries in a journal helps to prevent errors and enables us to identify mistakes effectively. A journal gives us a complete record of each transaction entered in the accounting information system. A journal entry refers to an individual transaction that has been entered in the journal, and provides information regarding the date the transaction is entered, which accounts are debited, which accounts are credited, and the corresponding transaction amounts. The process of recording transactions in a journal is called journalizing. The gen eral journal is flexible in that it can be used to record any economic transaction not captured in a special journal, and is typically used in practice to record non- routine transactions. Special journals are used to capture journal entries relating to similar types of transactions. Examples of special journals include sales journal, cash receipts journal, cash disbursements journal, purchases journal, and the payroll journal. A journal entry includes the following information about each transaction: 1. Date of transaction 2. Titles of affected accounts with corresponding account number 3. Dollar amount of each debit and credit 4. Explanation of transaction Exhibit 2.12 shows how the first three transactions of Organico are Page 107 recorded chronologically using a general journal. Although businesses use computerized systems, this textbook will demonstrate the processes of journalizing and posting using a manual system to ensure you have a strong foundation in accounting processes. Computerized journals and ledgers all operate on the same basic principles and processes as manual systems. EXHIBIT 2.12 Partial General Journal for Organico  GENERAL JOURNAL Page 1 Date Account Titles and Explanation PR Debit Credit 2023 Mar. 1 Cash 10,000 Hailey Walker, Capital 10,000 Investment by owner. Supplies 2,500 Cash 2,500 Purchased store supplies for cash. Supplies 1,100 Equipment 6,000 Accounts Payable 1,100 Notes Payable 6,000 Purchased supplies and equipment on credit. The third entry in Exhibit 2.12 uses four accounts. There are debits to the two assets purchased, Supplies and Equipment. There are also credits to the two sources of payment, Accounts Payable and Notes Payable. A transaction affecting two accounts is called a simple journal entry. A transaction affecting three or more accounts is called a compound journal entry. RECORDING JOURNAL ENTRIES Important Tip: Ensure Journal Entry Balances Total Debits = Total Credits Ensure total debits equal total credits—in other words, that the journal entry balances—before moving on to the next transaction. The posting reference (PR) column is left blank when a transaction is initially recorded. Individual account numbers are later entered into the PR column when entries are posted to the ledger. Computerized accounting software programs include error-checking routines that ensure that debits equal credits for each entry. Shortcuts often allow recordkeepers to enter account numbers instead of names, and to enter account names and numbers with pull-down menus. POSTING JOURNAL ENTRIES To ensure that the ledger is up to date, entries are posted as soon as possible. This might be daily, weekly, or monthly. Electronic journal entries entered in computerized accounting software are posted each time a journal entry is recorded. All entries must be posted to the ledger by the end of a reporting period. Updating account balances in a timely manner to reflect current values is especially important when financial statements are prepared. The ledger is the final destination for individual transactions; as such, it is referred to as the book of final entry. To demonstrate the posting process, Exhibit 2.13 shows the six key Page 108 steps to post a manual journal entry from the general journal to the individual ledger accounts. When posting manual entries to the ledger, the debits in journal entries are copied into ledger accounts as debits (as illustrated using the Cash ledger account below), and credits are copied into the ledger as credits (as illustrated using the Hailey Walker, Capital ledger account below). This process of recording the journal entry into the individual ledger accounts is covered automatically in a computerized accounting system. EXHIBIT 2.13 Posting a Manual Journal Entry to the Ledger Accounts Posting occurs after debits and credits for each transaction are entered into a journal. This process leaves a helpful trail that can be followed in checking for accuracy. T-accounts are a useful tool to demonstrate the posting of journal entries to the ledger accounts and determining the impact of a transaction on the account balance. For each journal entry, the usual process is to post debit(s) and then credit(s). Page 109 Six-Step Process to Post a Manual Journal Entry to the Ledger ① Identify the ledger account that was debited in the journal entry. ② Enter the date of the journal entry in this ledger account. ③ Enter the source of the debit in the PR column, both the journal and page. The letter G shows it came from the general journal.* ④ Enter the amount debited from the journal entry into the Debit  column of the ledger account. ⑤ Calculate and enter the account’s new balance in the Balance column. ⑥ Enter the ledger account number in the PR column of the journal entry. *Other journals are identified by their own letters. We discuss other journals later in the book. Repeat the six steps for credit amounts and Credit columns. Notice that posting does not create new information; posting simply transfers (or copies) information from the general journal to the appropriate account in the ledger. Step six in the posting process for both debit and credit amounts of an entry inserts the account number in the journal’s PR column. This creates a cross-reference between the ledger and the journal entry for tracing an amount from one record to another. T-Accounts T-accounts are used to demonstrate the impact of posting the transactions to the general ledger accounts. Refer to Exhibit 2.4 and Exhibit 2.5 for an explanation of T-accounts. Remember that in a double-entry accounting system we always have a minimum of two accounts included in each journal entry posted and we need to ensure that the journal entry is balanced, meaning the total dollar value of debits equals the total dollar value of credits. Computerized Systems Computerized systems require no added effort to post journal entries to the ledger. These systems automatically transfer debit and credit entries from the journal to the individual ledger accounts in the database. Journal entries are posted directly to ledger accounts. Many systems have controls built into the software that test the reasonableness of a journal entry and the account balance when recorded. For example, a payroll program might alert a preparer to hourly wage rates that are greater than $100. They also will prevent the user from posting an unbalanced journal entry. NEED-TO-KNOW 2-3 Recording Transactions LO5 Tata Company began operations on January 1 and completed the following transactions. For each transaction, (a) analyze the transaction using the accounting equation, (b) record the journal entry, and (c) post the entry using T-accounts as ledger accounts. Jan. 1 Jamsetji Tata invested $4,000 cash in the Tata Company. 5 Tata Company purchased $2,000 of equipment on credit. 14 Tata Company provided $540 of services for a client on credit. Solution Jan. 1 Receive Investment by Owner Jan. 5 Purchase Equipment on Credit  Jan. 14 Provide Services on Credit Do More: QS 2-6 through QS 2-14, E 2-2 through E 2-9, E 2-11 through E 2-17 Page 110 Financial Statement Impact of Transaction It is helpful to assess overall what the big-picture impact is to the accounting equation after posting the transactions to T-accounts. This process serves as a double-check that the entry we recorded is keeping the accounting equation in balance. We need to determine which elements of the accounting equation are increasing and which are decreasing. Assets = Liabilities + Owner’s Equity For example, if assets increase then either a corresponding asset decreased or liabilities or owner’s equity must have increased. To illustrate, when a company purchases new supplies it either pays cash (resulting in a decrease to assets) or incurs a liability for future payment, referred to as accounts payable (increasing a liability). The impact of accounting transactions to the accounting equation is illustrated in the following section. CHECKPOINT 6. Assume Maria Sanchez, the owner of a new business called La Casa de Cafe, invested $15,000 cash and equipment with a market value of $23,000. Assume that La Casa de Cafe also took responsibility for an $18,000  note payable issued to finance the purchase of equipment. Prepare the journal entry to record Sanchez’s investment. 7. Explain what a compound journal entry is. 8. Why are posting reference numbers entered in the journal when entries are posted to accounts?  Page 111 Accounting Transactions in Action We return to the first activities of Organico as Hailey Walker launches the food truck business to show how debit and credit rules and double-entry accounting are useful in analyzing and processing transactions. We analyze Organico’s transactions and demonstrate how these entries are journalized and posted to T- accounts using the following six micro steps: Step one analyzes a transaction. Step two applies double-entry accounting to identify the effect of a transaction on account balances. Step three analyzes the journal entry required to record the transaction. Step four records the journal entry, and includes a description of the journal entry. In step four it is critical that you ensure your total debits equal your total credits. Step five uses T-accounts to post the transaction to ledger accounts and identifies the effect of a transaction on account balances. Step six determines the big-picture financial statement impact of the transaction on Assets, Liabilities, and Equity. We should study each transaction thoroughly before proceeding to the next transaction. The first 11 activities are familiar to us from Chapter 1. We expand our analysis of these items and consider four new transactions (numbered 12 through 15) of Organico. 1. Investment by owner. Transaction. Hailey Walker invested $10,000 in Organico on March 1, 2023. Mar. 1 Cash 10,000 Financial Statement Hailey Walker, Capital 10,000 Impact. A = L + E* Investment by owner. ↑ ↑ *The effect of each transaction on the accounting equation is repeated here from Chapter 1 to help you transition to debits and credits. Analysis. Assets increase as business receives cash. Equity increases due to owner investment. Post to Ledger. Cash 101 (1) 10,000 Journal Entry Analysis. Assets increased, debit cash $10,000. Equity increased, credit Hailey Walker, Capital account for $10,000. Journal Entry. Debit the Cash asset account for $10,000. Credit the Hailey Walker, Capital account in equity for $10,000. Hailey Walker, Capital 301 10,000 (1) 2. Purchase supplies for cash. Page 112 Transaction. March 1, Organico purchases supplies by paying $2,500 cash. Journal Entry. Mar. 1 Supplies 2,500 Financial Statement Cash 2,500 Impact. A = L + E Purchased store supplies for cash. ↑↓ Analysis. Assets increase as supplies are brought in. Assets decrease as cash is spent. This changes the composition of assets, but does not change the total amount of assets. Post to Ledger. Supplies 125 (1) 2,500 Journal Entry Analysis. Assets increased, debit the Supplies asset account for $2,500. Assets decreased, credit the Cash asset account for $2,500. Cash 101 10,000 2,500 (2) 3. Purchase equipment and supplies on credit. Transaction. March 4, Organico purchases $1,100 of supplies and $6,000 of equipment on credit. Organico signs a promissory note, agreeing to pay for the $6,000 of equipment at a future date. Journal Entry. Mar. 4 Supplies 1,100 Financial Equipment 6,000 Statement Impact. Accounts Payable 1,100 Notes Payable 6,000 A = L + E ↑ ↑ Purchased supplies and equipment on credit. Analysis. Assets increase as equipment and supplies are brought into the company for use. Liabilities increase as the company purchases on a short- term credit arrangement for supplies and a longer-term credit arrangement for the equipment. Post to Ledger. Supplies 125 (2) 2,500 (3) 1,100 Journal Entry Analysis. Assets increased for equipment and supplies, debit Supplies for $1,100 and debit Equipment for $6,000. Liabilities increase; credit Accounts Payable for $1,100 and credit Notes Payable for $6,000. Equipment 167 (3) 6,000  Accounts Payable 201 1,100 (3) Notes Payable 240 6,000 (3) 4. Services rendered for cash. Transaction. On March 10, Organico sets up the truck outside a concert facility before a sold-out venue and sells $2,200 worth of burritos for cash. Journal Entry. Mar. 10 Cash 2,200 Financial Statement Food Services Revenue 2,200 Impact. A = L + E Food truck sales for cash. ↑ ↑ Analysis. Assets increase as cash is collected. Equity increases from Page 113 earned Revenue. Post to Ledger. Cash 125 (1) 10,000 2,500 (2) (4) 2,200 Journal Entry Analysis. Assets increase; debit the Cash asset account for $2,200. Equity increases; credit the Food Services Revenue account for $2,200. Food Services Revenue 403 2,200 (4) 5. Payment of expense in cash. Transaction. On March 10, Organico pays $1,000 cash for March rent. Journal Entry. Mar. 10 Rent Expense 1,000 Financial Statement Cash 10,000 Impact. A = L + E Payment of March rent. ↓ ↓ Analysis. Assets decrease as payment for rent is made out of cash. Equity decreases due to Expense incurred. Post to Ledger. Rent Expense 641 (5) 1,000 Journal Entry Analysis. Equity decreases, debit the Rent Expense account for $1,000 (this decreases equity). Assets decrease; credit the Cash asset account for $1,000. Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,000 (5) 6. Payment of expense in cash. Transaction. On March 10, Organico pays $700 cash for employee’s salary for the pay period ending on March 14. Journal Entry. Mar. 10 Salaries Expense 700 Financial Statement Cash 700 Impact. A = L + E Payment of employee salaries. ↓ ↓ Analysis. Assets decrease to due cash payment. Equity decreases due to Expense incurred. Post to Ledger. Salaries Expense 622 (6) 700 Journal Entry Analysis. Equity decreases due to expense incurred, debit the Salaries Expense account for $700. Assets decrease; credit the Cash asset account for $700. Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,000 (5) 700 (6) 7. Service contract signed for April. Event. On March 11, the accounting club at the local university and Hailey Walker sign a $2,700 contract that requires Organico to provide food for a group of graduating students at a CPA recruitment event. Organico has agreed to attend the event to be held in April. Analysis. There has been no economic exchange between two parties (the services have not been provided and Organico did not receive any assets); therefore, this has no effect on the accounting equation. 8. Services and rental revenues rendered on credit. Page 114 Transaction. On March 17, Organico provided catering for a corporate event for $1,600 and taught a fresh Mexican cooking class for $300. The customer is billed $1,900 for the services and Organico expects to collect this money in the near future. Journal Entry. Mar. 17 Account Receivable 1,900 Financial Statement Food Services Revenue 1,600 Impact. Teaching Revenue 300 A = L + E Customer billed for services provided. ↑ ↑ Analysis. Assets increase as customer is billed for services provided. Equity increases due to earned Revenue. Post to Ledger. Accounts Receivable 106 (8) 1,900 Journal Entry Analysis. Assets increase; debit the Accounts Receivable asset account for $1,900. Equity increases; credit two revenue accounts: Food Services Revenue for $1,600 (this increases equity) and Teaching Revenue for $300 (this increases equity). Food Services Revenue 403 2,200 (4) 1,600 (8) Teaching Revenue 406 300 (8) 9. Receipt of cash on account. Transaction. On March 27, an amount of $1,900 is received from the customer in Transaction 8. Journal Entry. Mar. 27 Cash 1,900 Financial Statement Accounts Receivable 1,900 Impact. A = L + E Collection of cash from customer. ↑↓ Analysis. Assets increase as cash is received. Assets decrease, as customer obligation to pay is no longer outstanding. This changes the composition of assets, but does not change the total amount of assets. Post to Ledger.  Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,000 (5) (9) 1,900 700 (6) Journal Entry Analysis. Debit the Cash asset account for $1,900. Credit the Accounts Receivable asset account for $1,900. Accounts Receivable 106 (8) 1,900 1,900 (9) 10. Partial payment of accounts payable. Transaction. On March 27, Organico pays CanFood Supply $900 cash toward the account payable of $1,100 owed from the purchase of supplies in Transaction 3. Journal Entry. Mar. 27 Accounts Payable 900 Financial Statement Cash 900 Impact. A = L + E Cash payment to supplier. ↓ ↓ Analysis. Assets decrease as cash is paid. Liabilities decrease as $900 of the obligation is settled. Post to Ledger. Accounts Payable 201 (10) 900 1,100 (3) Journal Entry Analysis. Liabilities decrease; debit the Accounts Payable liability account for $900. Assets decrease; credit the Cash asset account for $900. Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,100 (5) (9) 1,900 700 (6) 900 (10) 11. Withdrawal of cash by owner. Page 115 Transaction. On March 28, Hailey Walker withdraws $600 from Organico for personal living expenses. Journal Entry. Mar. 28 Hailey Walker, Withdrawals 600 Financial Statement Cash 600 Impact A = L + E Withdrawal of cash by owner. ↓ ↓ Analysis. Equity decreases as owner extracts equity from the business. Assets decrease as cash is withdrawn. Post to Ledger. Hailey Walker, Withdrawals 302 (11) 600 Journal Entry Analysis. Equity decreases; debit the Hailey Walker, Withdrawals account for $600. Assets decrease, credit the Cash asset account for $600. Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,000 (5) (9) 1,900 700 (6) 900 (10) 600 (11) 12. Receipt of cash for future services. Transaction. On March 29, Organico enters into (signs) a contract with a local advertising agency to provide food for a series of Tuesday “Train the Trainer” ski/snowboard instructor training events at a local ski hill called Mount Mundy. Organico receives $3,000 cash in advance of the event. Journal Entry. Mar. 29 Cash 3,000 Financial Statement Unearned Food Services Revenue 3,000 Impact A = L + E Collection of payment for future services. ↑ ↑ Analysis. Assets increase as cash is received. Liabilities increase as accepting the $3,000 cash obligates Organico to provide food services for the event next month, classified for accounting purposes as unearned revenue. No revenue is earned until services are provided. Post to Ledger. Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,000 (5) (9) 1,900 700 (6) (12) 3,000 900 (10) 600 (11) Journal Entry Analysis. Assets increase, debit the Cash asset account for $3,000. Liability incurred, credit Unearned Food Services Revenue this is a liability account for $3,000. Unearned Food Services Revenue 236 3,000 (12) 13. Payment of cash for future insurance coverage. Page 116 Transaction. On March 30, Organico pays $2,400 cash (premium) for a two-year insurance policy. Coverage begins on May 1. Journal Entry. Mar. 30 Prepaid Insurance 2,400 Financial Statement Cash 2,400 Impact A = L + E Payment for insurance coverage. ↑↓ Analysis. Assets increase as company benefits from having insurance coverage for the next two years. Assets decrease as cash is expended. This changes the composition of assets from cash to a “right” of insurance coverage. Expense will be incurred monthly as the benefit of the insurance coverage is utilized through the passage of time. Post to Ledger. Prepaid Insurance 128 (11) 2,400 Journal Entry Analysis. Asset increases, debit the Prepaid Insurance asset account for $2,400. Asset decreases, credit the Cash asset account for $2,400. Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,000 (5) (9) 1,900 700 (6) (12) 3,000 900 (10) 600 (11) 2,400 (13) 14. Payment of expense in cash. Transaction. On March 31, Organico pays $230 cash for March Internet/phone connectivity/usage. Journal Entry. Mar. 31 Communications Expense 230 Financial Statement Cash 230 Impact A = L + E Payment of March Communications. ↓ ↓ Analysis. Assets decrease as cash is expended. Equity decreases due to Expense incurred. Post to Ledger. Communications Expense 690 (14) 230 Journal Entry Analysis. Equity decreases, debit the Communications Expense account for $230 (this decreases equity). Asset decreases, credit the Cash asset account for $230. Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,000 (5) (9) 1,900 700 (6) (12) 3,000 900 (10) 600 (11) 2,400 (13) 230 (14) 15. Payment of expense in cash. Transaction. On March 31, Organico pays $700 cash for employee’s salary for the two-week pay period ending on March 28. Journal Entry. Mar. 31 Salaries Expense 700 Financial  Cash 700 Statement Payment of employee wages. Impact A = L + E ↓ ↓ Analysis. Assets decrease as cash is expended. Equity decreases through Expenses incurred. Post to Ledger. Salaries Expense 622 (6) 700 (15) 700 Journal Entry Analysis. Equity decreases, debit the Salaries Expense account for $700. Assets decrease; credit the Cash asset account for $700. Cash 101 (1) 10,000 2,500 (2) (4) 2,200 1,000 (5) (9) 1,900 700 (6) (12) 3,000 900 (10) 600 (11) 2,400 (13) 230 (14) 700 (15)  Page 117 Accounting Equation Analysis Exhibit 2.14 shows Organico’s accounts in the ledger after all March transactions are recorded and the balances calculated. For emphasis, the accounts are grouped into three major columns representing the terms in the accounting equation: assets, liabilities, and equity. EXHIBIT 2.14 Ledger for Organico at March 31, 2023 Assets = Liabilities + Cash 101 Accounts Payable 201 Hailey Walk (1) 10,000 2,500 (2) (10) 900 1,100 (3) (4) 2,200 1,000 (5) 200 Balance (9) 1,900 700 (6) (12) 3,000 900 (10) 600 (11) 2,400 (13) Unearned Food 236 Hailey W Services Revenue Withdr 230 (14) 3,000 (12) (11) 6 700 (15) 3,000 Balance Balance 6 Balance 8,070 Food Servic Accounts Receivable 106 Notes Payable 240 (8) 1,900 1,900 (9) 6,000 (3) Balance 0 6,000 Balance Supplies 125 Teaching (2) 2,500 (3) 1,100 Balance 3,600 Salaries Prepaid Insurance 128 (6) 7  Assets = Liabilities + (13) 2,400 (15) 7 Balance 2,400 Balance 1,4 Equipment 167 Rent Ex (3) 6,000 (5) 1,0 Balance 6,000 Balance 1,0 Accounts in the white area Commun reflect increases and decreases Expe in equity. Their balances are reported on the income (14) 2 statement or the statement of Balance 2 changes in equity TOTALS: $20,070* = $9,200** + *$8,070 + $0 + $3,600 + $2,400 + $6,000 = $20,070 **$200 + $3,000 + $6,000 = $9,200 †$10,000 – $600 + $3,800 + $300 – $1,400 – $1,000 – $230 = $10,870 DECISION MAKER Accounting Clerk Congratulations! You recently got a job as a part-time accounting clerk for a local coffee shop to earn money while you attend school. Today, your employer, the owner of the business, made some purchases and instructed you to debit Office Supplies and credit Accounts Payable for the entire amount. He tells you that the invoice is for a few office supplies but mainly for some items that he needed for personal use at home. Explain which GAAP is being violated, and the impact of this error on the financial statements of the business. Answer—End of chapter  Exhibit 2.14 highlights three important points. 1. The totals for the three columns show that the accounting equation is in balance 2. The owner’s investment is recorded in the capital account and the withdrawals, revenue, and expense accounts reflect the transactions that change equity. Their ending balances make up the statement of changes in equity. 3. The revenue and expense account balances are summarized and reported in the income statement. CHECKPOINT 9. Does “debit” always mean increase and “credit” always mean decrease? 10. What kinds of transactions increase equity? What kinds decrease equity? 11. Why are most accounting systems called double entry? 12. Double-entry accounting requires that (select the best answer): a. All transactions that create debits to asset accounts must create credits to liability or equity accounts. b. A transaction that requires a debit to a liability account also requires a credit to an asset account. c. Every transaction must be recorded with total debits equal to total credits. Do Quick Study questions: QS 2-6, QS 2-7, QS 2-8, QS 2-9, QS 2-10, QS 2-11, QS 2-12, QS 2-13, QS 2-14 Page 118 Mid-Chapter Demonstration Problem Kara Morris founded her dream business, called Kara’s Kiteboarding Adventures. The following transactions occurred during June 2023, her first month of operations. a. Kara invested $15,000 cash into the business on June 1. b. Kara’s Kiteboarding paid $400 to cover insurance for the month of June. c. June 3, Kara’s Kiteboarding purchased $12,000 worth of kiteboarding equipment on credit. d. June 6, the business rented additional kiteboarding equipment for $1,500 on account. e. June 9, the business provided lessons to a group of clients for $3,500 on account. f. June 14, the business collected $2,000 from its credit customers. g. The kiteboarding equipment purchased June 3, on credit was paid for June 28. Required 1. Open the following T-accounts: Cash; Accounts Receivable; Equipment; Accounts Payable; Kara Morris, Capital; Teaching Revenue; Insurance Expense; Equipment Rental Expense. 2. Post the June entries directly into the T-accounts. Analysis Component: Using your answer in Part 2, prove that the accounting equation balances at the end of June. SOLUTION 1 and 2. Cash Accounts Receivable Equipme (a) 15,000 400 (d) (e) 3,500 2,000 (f) (b) 12,000 (f) 2,000 12,000 (g) (Bal.) 46,00 (Bal.) 1,500  Kara Morris, Capital Teaching Revenue Insurance Ex 15,000 (a) 3,500 (e) (d) 400 Analysis Component: Total assets = Cash 4,600 + Accounts Receivable 1,500 + Equipment 12,000 = 18,100 Total liabilities = Accounts Payable 1,500 Total equity = Kara Morris, Capital 15,000 + Teaching Revenue 3,500 – Insurance Expense 400 – Equipment Rental Expense 1,500 = 16,600 Assets 18,100 = Liabilities 1,500 + Equity 16,600 18,100 = 18,100 Page 119 LEDGERS As highlighted previously, T-accounts are a simple and direct learning tool to show how the accounting process works. They allow us to omit less relevant details and concentrate on calculating the balance in a specific account. Once journal entries are recorded in the appropriate journal, transaction details need to be posted to the appropriate ledger. Ledgers contain financial statement activity for each specific account. A general ledger summarizes each financial statement account, providing a total balance in each account used in the organization’s chart of accounts. Detailed information on account activity is required to be maintained in subsidiary ledgers; the control account in the general ledger contains the total balance for each account. The accounts receivable subsidiary ledger, for example, maintains specific information regarding each customer’s account history, including sales invoice details and information regarding customer cash payments. Exhibit 2.15 provides an example of the cash control account detail in the general ledger for Organico. EXHIBIT 2.15 Cash Control Account in General Ledger Cash Account No. 101 Date Explanation PR Debit Credit Balance 2023 Mar. 1 G1 10,000 10,000 1 G1 2,500 7,500 10 G1 2,200 9,700 The T-account was derived from the ledger account format and it too has Page 120 a column for debits and a column for credits. Look at the imaginary T-account superimposed over Exhibit 2.15. The ledger account is different from a T- account because it includes a transaction’s date and explanation and has a third column with the balance of the account after each entry is posted. This means that the amount on the last line in this column is the account’s current balance. For example, Organico’s Cash account in Exhibit 2.15 is debited on March 1 for the $10,000 investment by Hailey Walker. The account then shows a $10,000 debit balance. The account is also credited on March 1 for $2,500, and its new $7,500 balance is shown in the third column. The Cash account is debited for $2,200 on March 10, and its balance increases to a $9,700 debit. Abnormal Balance Unusual transactions can sometimes give an abnormal balance to an account. An abnormal balance refers to a balance on the side where decreases are recorded. For example, a customer might mistakenly overpay a bill. This gives that customer’s account receivable an abnormal credit balance.9 It is helpful to be alert for abnormal balances as they may be as a result of an error in recording a journal entry. Zero Balance A zero balance for an account is usually shown by writing zeros or a dash in the Balance column. This practice avoids confusion between a zero balance and one omitted in error. Page 121 PERSONAL FINANCE SERIES How to Plan Ahead for Unexpected Expenses In Chapter 1 we outlined how to create an effective budget to ensure you have control over how you choose to spend your money. One of the biggest reasons people fall behind in their finances and incur expensive credit card debt is due to a failure in planning ahead. At first this may seem counterintuitive—how can I plan for something I don’t know will occur? Common expenses that are not generally included in a detailed budget include things such as a broken down car, an unexpected vet bill for a loved pet, unexpected medical costs including dental bills, a broken cellphone that needs replacing, budgeted costs that are not covered as a result of missed work due to illness, and so on. According to research by MoneySense, during the COVID-19 global pandemic in 2020 many people found themselves without an emergency fund, and their unexpected expenses were being covered “with a credit card … payday loans, or heavily using your … unsecured line of credit.” All of these are high-interest options, and the interest piles up if you can’t pay the money back in full. Your average credit card charges interest on outstanding balances at an annual percentage rate (APR) of 19.99%, and can be as high as 29.99%. At a rate of 19% that means if you put your $2,000 expense on a credit card and are able to pay only $50 per month, it will take 67 months to pay off the balance and you will pay $1,321 in interest.* Although these items are difficult to include in your budget until they come up, you can plan ahead to be able to cover these costs so they don’t set you back. According to the government of Canada, 29% of Canadians owe money on their credit cards. This illustration shows you why it is better to plan ahead: by saving ahead, you would have prevented yourself from losing $1,321 in interest charges. How much should I save in my contingency fund? A rule of thumb is you should have 3 to 6 months worth of your budgeted monthly expenses. The larger the cushion, the stronger you will be financially to withstand unexpected emergencies. As suggested by MoneySense, ask yourself the following questions to determine when it is appropriate to use your emergency funds: 1. Is the event unexpected? 2. Is the event necessary? 3. Is the event urgent? Next chapter: We will identify why developing a savings plan is one of the best financial habits you can develop. *How much you owe on outstanding balances is calculated daily and you are charged interest on both the amount you initially spent on your card and the daily interest charges you keep incurring. This is referred to as compounding. In this example, each day your balance is outstanding you are charged (0.19/365) = 0.052% daily periodic rate.  Sources: https://www.savewithspp.com/2020/08/20/about-one-third-of-canadians-lack-an-emergency- fund-here-are-some-tips-to-get-you-started/; https://www.bankrate.com/calculators/credit-cards/credit- card-payoff-calculator.aspx; https://www.moneysense.ca/save/budgeting/what-is-an-emergency-fund- and-how-to-build-one/; https://www.canada.ca/en/financial-consumer- agency/programs/research/canadian-financial-capability-survey-2019.html TRIAL BALANCE LO6 Prepare and explain the use of a trial balance. Double-entry accounting records every transaction with equal debits and credits. An error exists if the sum of debit entries in the ledger does not equal the sum of credit entries. The sum of debit account balances must always equal the sum of credit account balances. Step four of the accounting cycle shown in Exhibit 2.1 requires the preparation of a trial balance to check whether debit and credit account balances are equal. A tr ial balance is a list of accounts and their balances at a point in time. Account balances are reported in the debit or credit column of the trial balance. Exhibit 2.16 shows the trial balance for Organico after the entries described earlier in the chapter are posted to the ledger. Page 122 EXHIBIT 2.16 Trial Balance Organico Trial Balance March 31, 2023 Acct. No. Account Debit Credit 101 Cash $ 8,070 106 Accounts receivable -0-  Organico Trial Balance March 31, 2023 125 Supplies 3,600 128 Prepaid insurance 2,400 167 Equipment 6,000 201 Accounts payable $ 200 236 Unearned food services revenue 3,000 240 Notes payable 6,000 301 Hailey Walker, capital 10,000 302 Hailey Walker, withdrawals 600 403 Food Services revenue 3,800 406 Teaching revenue 300 622 Salaries expense 1,400 641 Rent expense 1,000 690 Communications expense 230 Totals $23,300 $23,300 Another use of the trial balance is as an internal report for preparing financial statements. Preparing statements is easier when we can take account balances from a trial balance instead of searching the ledger. The preparation of financial statements using a trial balance is illustrated in the end-of-chapter Demonstration Problem. We expand on this process in Chapter 3. Preparing a Trial Balance Preparing a trial balance involves five steps: 1. Identify each account balance from the ledger. 2. List each account and its balance (in the same order as in the Chart of Accounts). Debit balances are entered in the Debit column and credit balances are entered in the Credit column.10  3. Calculate the total of debit balances. 4. Calculate the total of credit balances. 5. Verify that total debit balances equal total credit balances. Notice that the total debit balance equals the total credit balance for the trial balance in Exhibit 2.16. If these two totals were not equal, we would know that one or more errors exist. Equality of these two totals does not guarantee the absence of errors. Page 123 Using a Trial Balance We know that one or more errors exist when a trial balance does not balance (when its columns are not equal). When one or more errors exist, they often arise from one of the following five steps in the accounting process: 1. Preparing journal entries 2. Posting entries to the ledger 3. Calculating account balances 4. Copying account balances to the trial balance 5. Totalling the trial balance columns When a trial balance does balance (total debits equal total credits), the accounts are likely free of the kinds of errors that create unequal debits and credits. Yet errors can still exist. One example is when a debit or credit of a correct amount is made to a wrong account. This can occur when either journalizing or posting. The error would produce incorrect balances in two accounts but the trial balance would balance. Another error is to record equal debits and credits of an incorrect amount. This error produces incorrect balances in two accounts but again the debits and credits are equal. We give these examples to show that when a trial balance does balance, it does not prove that all journal entries are recorded and posted correctly. In a computerized accounting system, the trial balance would always balance. Accounting software is such that unbalanced entries would not be accepted by the system. However, errors as described in the last paragraph can still exist in a computerized system. Page 124 ETHICAL IMPACT International Ethics: Corporate Corruption vs. Cross-Cultural Management According to Transparency International, “68% of countries worldwide have a serious corruption problem, and not one single country worldwide is corruption free.” Consider the following business scenario: you work for a water distribution firm and recently won a contract to set up a new pump system in a small village in East Africa. The dollar value of the contract is $20 million and is going to be funded by a U.S. charity. How would you respond if you were asked by the local East African government to contribute $500,000 to help build a new hospital to support that region? What would you do? Image Flow/Shutterstock Jeffrey Fadiman, in his article “A Traveller’s Guide to Gifts and Bribes,” suggests that it is important to understand the culture of the region with which you engage in business in order to understand how to manage these types of requests. It would be prudent to understand the viewpoint of the government and circumstances behind the request that is made, as well as Canadian laws regarding foreign payments of this nature to determine the appropriate action to take. Sources: “A Traveller’s Guide to Gifts and Bribes,” Harvard Business Review, July 1986, https://hbr.org/1986/07/a-travelers-guide-to-gifts-and-bribes; “Corruption Perception Index,” Transparency International, https://www.transparency.org/cpi2015. NEED-TO-KNOW 2-4 Preparing a Trial Balance LO6 Prepare a trial balance for Accel using the following information from its current year ended December 31. Accounts payable $7,700 Wages payable 13,000 Rent expense 7,000 Cash 17,000 Services revenue 41,000 B. Accel, Withdrawals 12,500 Land 30,000 Equipment 27,000 Wages expense 21,000 Accounts receivable 5,000 B. Accel, Capital 58,000 Solution ACCEL Trial Balance December 31  ACCEL Debit Credit Trial Balance December 31 Debit Credit Cash $ 17,000 Accounts receivable 5,000 Equipment 27,000 Land 30,000 Accounts payable $ 7,500 Wages payable 13,000 B. Accel, Capital 58,000 B. Accel, Withdrawals 12,500 Services revenue 41,000 Rent expense 7,000 Wages expense 21,000 Totals $119,500 $119,500 Do More: QS 2-15, QS 2-16, E 2-9, E 2-11, E 2-16 through E 2-22 Page 125 Searching for Errors When performing accounting manually, if the trial balance does not balance the error (or errors) must be found and corrected before financial statements are prepared. To search for the error, we check the journalizing, posting, and trial balance preparation process in reverse order. Otherwise, we would need to look at every transaction until the error was found. The steps involved are:  1. Verify that the trial balance columns are correctly added. If this fails to show the error, then 2. Verify that account balances are accurately copied from the ledger. 3. Determine if a debit or credit balance is mistakenly listed in the trial balance as a credit or debit. Look for this when the difference between total debits and total credits in the trial balance equals twice the amount of the incorrect account balance. 4. Recalculate each account balance. If the error remains, then 5. Verify that each journal entry is properly posted to ledger accounts. 6. Verify that the original journal entry has equal debits and credits. One frequent error is called a transposition error, in which two digits are switched or transposed within a number (e.g., 619 instead of 691). Another type of error, a slide,11 occurs when adding or deleting a zero (or zeros) in a value (e.g., 32 instead of 320). If a transposition or a slide is the only error, then the difference between the totals of the trial balance columns will be evenly divisible by 9. For example, to find a transposition error: 1. Subtract total debits in the trial balance from total credits. Based on the transposition given above, the difference between total debits and credits is $72 ($691 − $619) 2. Divide the difference by 9. $72 ÷ 9 = 8 3. The quotient equals the difference between the two transposed numbers. 8 is the difference between 9 and 1 in both 91 of 691 and 19 of 619. 4. The number of digits in the quotient tells us the location of the transposition. The quotient of 8 is only one digit, so the transposition can be found by checking the first digit from the right in each number.12 Formatting Conventions Dollar signs are not used in journals and ledgers. They do appear in financial statements and other reports, including trial balances, to identify the kind of currency being used. This book follows the usual practice of putting a dollar sign beside the first amount in each column of numbers and the first amount appearing after a ruled line that indicates that an addition or subtraction has been performed. The financial statements in Exhibit 1.16 demonstrate how dollar signs are used in this book. Different companies use various conventions for dollar signs. When amounts are entered manually in a formal journal, ledger, or trial Page 126 balance, commas are not needed to indicate thousands, millions, and so forth. Also, decimal points are not needed to separate dollars and cents. If an amount consists of even dollars without cents, a convenient shortcut uses a dash in the cents column instead of two zeros. However, commas and decimal points are used in financial statements and other reports. An exception is when this detail is not important to users. It is common for companies to round amounts to the nearest dollar, and to an even higher level for certain accounts. Recipe Unlimited Corporation is typical of many companies in that it rounds its financial statement amounts to the nearest thousand dollars. CHECKPOINT 13.