Lecture #2: Recording Transactions

Accounting provides quantitative information about economic entities.

Two types of transactions

1. Business transactions - These transactions occur between the entity and an outside party.

2. Internal transactions - Transactions that affect the financial statements, but does not result from an outside party.

Business papers.

Printed documents that businesses use in the process of completing transactions.

→ These are evidence of business transactions and the basis for entry into the accounting records.

→ These are verifiable records between your business and another business.

Accounts

Business transactions must be recorded and stored in separate locations, so they can be sorted and combined when the financial reports are prepared.

Accounts Commonly Used

A business uses a number of accounts to record and store the effects of its transactions.

1. Asset Accounts.

1. Cash: Consists of money and any other medium of exchange.
2. Notes Receivable: A promissory note is an unconditional written promise to pay a definite sum of money on demand at some specific date in the future.
3. Accounts Receivable: Goods and services are commonly sold to customers on the basis of oral or implied promises of future payment.
4. Prepaid Insurance: Fire, liability, and other types of insurance protection are normally paid in advance.
5. Office Supplies: When stamps, stationary, paper, pencils, and other items are bought for the office, they are assets that are recorded here. When these assets are used up, then they are transferred to expense accounts.
6. Other Prepaid Expenses: When payments are made for economic benefits that do not expire until some later time.
7. Equipment: Physical assets are recorded here, such as computers, desks, chairs, and office machines.
8. Buildings: Buildings used by a business in carrying on its operations, such as a store, garage, warehouse, or factory.
9. Land: Increases and decreases of land owned by the business is recorded here. Land and buildings are separated, because buildings deteriorate and depreciate over time, while land does not.

2. Liability Accounts - They are present obligations to transfer assets or provide services to other entities in the future.

1. Notes Payable: A formal written promise to pay a definite sum of money at a fixed future date.
2. Accounts Payable: When purchases are made on the basis of oral or implied promises to pay.
3. Unearned Revenue: Revenue cannot be recognized until it is earned. If a company collects money before its products are delivered, then this transaction must be recorded in an Unearned Revenue account. When the products are delivered, then the amount earned would be transferred to the revenue accounts.
4. Other Short-Term Payables: Wages payable, taxes payable, and interest payable. Each account requires their own separate account.

3. Owner’s Equity Accounts - The owner’s equity is broken-down into three accounts.

1. Capital Account.: When a person invests in his own business, the investment is recorded in an account carrying the owner’s name and the word capital. The capital account is used for any permanent additional increases or decreases in owner’s equity.
2. Withdrawal Account: When the business earns net income, the equity of the business increases. The owner needs money for living expenses or for other personal uses, so he can withdraw some of the business’s assets, which reduces owner’s equity.
3. Revenue and Expense Accounts: To prepare an income statement for a business, you have to know the amount of each kind of revenue and each kind of expense. Then you would have a number of expense and revenue accounts.

Debit and Credit

The T-account has a left side and a right side. The left side is called the debit side, while the right is called a credit side. The difference between total debits and total credits is called the account balance.

Transactions Illustrating the Rules of Debit and Credit.

We will be following the transactions for Jerry Dow’s law practice.

1. On Dec. 1, Jerry Dow invested $9,000 in a new law practice.
2. He purchased books for a law library, paying cash of $2,500.
3. He purchased office equipment for cash $5,600.
4. He purchased on credit from Equip-it Company law library items $380 and office equipment $1,280.
5. He completed legal work for a client and immediately collected a $2,200.
6. He paid the office rent for Dec. $1,000.
7. He paid the secretary’s salary for the two weeks ended Dec. 12, $700.
8. He completed legal work for a client and billed the client $1,700 for the services rendered.
9. The client paid the $1,700 legal fee billed in transaction 8.
10. He paid Equip-it Company $900 of the $1,660 owed for the items purchased on credit in transaction 4.
11. Jerry Dow withdrew $1,100 from the law practice for personal use.
12. He signed a contract with Chemical Supply to do its legal work on a fixed-fee basis for $500 per month. He received the fee for the first six months in advance $3,000.
13. He paid a $2,400 premium for liability insurance protection that lasts two years.
14. He purchased office supplies for cash $120.
15. He paid the Dec. utilities bill for electricity and water $230.
16. He paid the secretary’s salary for the two weeks ended on Dec. 26, $700.

You can test this equality be constructing a trial balance. To make one:

1. Determine the balance of each account in the ledger.

2. List the accounts with balances other than zero.

We are using T-accounts to teach you accounting. They are not used in the real world. Businesses use accounts that is illustrated below.

Note: Because of the equation:

Assets = Liabilities + Owner’s Equity

(Debit) (Credit) (Credit)

Transactions Should be First Recorded in a Journal

It is possible to record transactions by entering debits and credits directly in the accounts. If you make an error, the error will be difficult to locate, using this method, because there is no link between the credit and debit items in the ledger books.

To correct this problem, all transactions are first recorded in a journal, called the General Journal. From the journal, the information of the transactions is transferred to the accounts. This procedure reduces the tendency to make errors. If an error is made, then the General Journal makes it possible to locate the error.

The General Journal should contain the following information of each transaction.

1. The transaction date.
2. The names of the accounts involved.
3. The amount of each debit and credit.
4. An explanation of the transaction.
5. A column in which to mark the identifying number of the account to which each debit or credit was copied.

Account Numbers

All companies should follow a systematic method of assigning numbers to their accounts.

For example.

Locating Errors

When a trial balance does not balance, then an error has been made. To find the error:

1. Recalculate the column totals in the trial balance.
2. Check to see if the account balances were correctly copied from the ledger.
3. Recalculate the account balances.
4. Refer to the General Journal to see if transactions were correctly transferred from it to the ledger accounts.

When an error is discovered in either the journal or the ledger, it must be corrected. Never erase the error, because this may indicate an effort to conceal something.

For example.

An amount was posted to the wrong account.

You correct this error by using an entry in the journal.