Principles of Accounting, Volume 1: Financial Accounting

Chapter 3 - ANALYZING AND RECORDING TRANSACTIONS

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Chapter Outline

3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their

Relationship to Financial Statements
3.2 Define and Describe the Expanded Accounting Equation and Its Relationship
to Analyzing Transactions
3.3 Define and Describe the Initial Steps in the Accounting Cycle
3.4 Analyze Business Transactions Using the Accounting Equation and Show the
Impact of Business Transactions on Financial Statements
3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
3.6 Prepare a Trial Balance

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Module 3.1 Describe Principles, Assumptions, and Concepts
of Accounting and Their Relationship to Financial Statements

• The Financial Accounting Standards Board (FASB) is an independent, nonprofit

organization that sets the standards for financial accounting and reporting,
including generally accepted accounting principles (GAAP), for both public- and
private-sector businesses in the United States.
• GAAP are the concepts, standards, and rules that guide the preparation and
presentation of financial statements.
• US accounting rules are called US GAAP.
• International accounting rules are called International Financial Reporting
Standards (IFRS).
• Some companies that operate on a global scale may be able to report their financial
statements using IFRS.
• Publicly traded companies (those that offer their shares for sale on exchanges in the
United States) have the reporting of their financial operations regulated by
the Securities and Exchange Commission (SEC).
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The Conceptual Framework

The conceptual framework is a set of concepts that guide financial

reporting. These concepts help ensure information is comparable and
reliable to stakeholders.
• Revenue recognition principle: directs a company to recognize revenue in the
period in which it is earned; is earned when a product or service has been
provided
• Expense recognition (matching) principle: states that we must match expenses
with associated revenues in the period in which the revenues were earned
• Cost principle: states that virtually everything the company owns or controls
(assets) must be recorded at its value at the date of acquisition
• Full disclosure principle: states that a business must report any business activities
that could affect what is reported on the financial statements
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The Conceptual Framework (continued)
• Separate entity concept: prescribes that a business may only report activities on
financial statements that are specifically related to company operations, not
those activities that affect the owner personally
• Conservatism: states if there is uncertainty in a potential financial estimate, a
company should err on the side of caution and report the most conservative
amount
• Monetary measurement concept: must be a monetary unit by which to value the
transaction
• Going concern assumption: assumes a business will continue to operate in the
foreseeable future
• Time period assumption: states a company can present useful information in
shorter time periods, such as years, quarters, or months
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 Figure 3.2

GAAP Accounting Standards Connection Tree. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
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Accounting Equation

The accounting equation can be thought of from a “sources and claims”

perspective. Everything a company owns must equal everything the
company owes to creditors (lenders) and owners (individuals for sole
proprietors or stockholders for companies or corporations).

For the rest of the text, we switch the structure of the business to a
corporation, and instead of owner’s equity, we begin
using stockholder’s equity, which includes account titles such
as common stock and retained earnings to represent the owners’
interests.
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Double-Entry Bookkeeping
The basic components of even the simplest accounting system
are accounts and a general ledger.
• An account is a record showing increases and decreases to assets, liabilities, and
equity; each of these categories includes many individual accounts.
• A general ledger is a comprehensive listing of all of a company’s accounts with
their individual balances.
Recording transactions in the general ledger utilizes a double-entry
accounting system:
• Each time we record a transaction, we must record a change in at least two
different accounts. Having two or more accounts change will allow us to keep the
accounting equation in balance.
• Not only will at least two accounts change, but there must also be at least one
debit and one credit side impacted.
• The sum of the debits must equal the sum of the credits for each transaction. 8
Debits and Credits
In order for companies to record the myriad of transactions they have each
year, there is a need for a simple, but detailed, system. Each account can be
split into a right side and a left side.
• A debit (DR) records financial information on the left side of each account.
A credit (CR) records financial information on the right side of an account. One
side of each account will increase and the other side will decrease. The ending
account balance is found by calculating the difference between debits and
credits for each account.
• This graphic representation of a general ledger account is known as a T-account:

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Depending on the account type, the sides that increase and decrease will vary.

The normal balance is the expected balance each account type maintains,
which is the side that increases.
Account Normal Balances and Increases

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Module 3.2 Define and Describe the Expanded Accounting
Equation and Its Relationship to Analyzing Transactions

Accounting equation with expanded equity side:

Expanded Accounting Equation. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

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Various Asset Accounts
• Cash: includes paper currency as well as coins, checks, bank accounts, and money orders
• Accounts receivable: money that is owed to the company, usually from a customer
• Inventory: goods available for sale; are an asset until they are sold
• Supplies: (office supplies) include pens, paper, and pencils; considered assets until an
employee uses them, at which time they have lost their economic value and their cost is now
an expense to the business
• Prepaid expenses: items paid for in advance of their use, such as rent and insurance;
considered assets until used
• Notes receivable: similar to accounts receivable, is money owed to the company by a
customer or other entity, but includes interest and specific time payment terms
• Equipment: includes desks, chairs, and computers; has a long-term value and is considered a
long-term asset, meaning it can be used for more than one accounting period; will lose value
over time in a process called depreciation
• Buildings, machinery, and land: all considered long-term assets; building and machinery
depreciate; land is not depreciated 12
Figure 3.4

Assets. Cash, buildings, inventory, and equipment are all types of assets.
(credit clockwise from top left: modification of “Cash money! 140606-A-CA521-021” by Sgt. Michael Selvage/Wikimedia Commons, Public Domain;
modification of “41 Cherry Orchard Road” by “Pafcool2”/Wikimedia Commons, Public Domain; modification of “ASM-e1516805109201” by Jeff
Green, Rethink Robotics/ Wikimedia Commons, CC BY 4.0; modification of “Gfp-inventory-space” by Yinan Chen/Wikimedia Commons, CC0)
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Various Liability Accounts

• Accounts payable: recognizes that the company owes money and has
not paid
• Notes payable: similar to accounts payable in that the company owes
money and has not yet paid, but the terms are usually longer, are
typically more formal (written agreements), and include interest
• Unearned revenue: represents a customer’s advanced payment for a
product or service that has yet to be provided by the company; the
company cannot record revenue yet, and must record a liability, as
the company is liable to the customer to either complete the service
(or deliver the goods) or return the customer’s money.

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Equity Account Components

Stockholders’ equity is the owner’s (stockholders’)

investments in the business and earnings.
• Two components of stockholders’ equity:
• Contributed capital: amounts paid into the business for an ownership
interest (stock); business uses that money to grow and develop the
business
• Retained earnings: income that has been earned by the business but has
NOT been paid out in the form of dividends to the owners (stockholders)

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 Financial Statement and Accounting Equation
Interrelationships Review
Assets = Liabilities + Stockholders’ Equity
Assets = Liabilities + [Contributed Capital + Retained Earnings]
Assets = Liabilities + [Contributed Capital + {Beg. Retained Earnings + Net Income – Dividends}]
Assets = Liabilities + [Contributed Capital + {Beg. Retained Earnings + (Revenues – Expenses) – Dividends}]

Income Statement

Statement of Stockholders’ (Owners’) Equity

Balance Sheet
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Module 3.3 Define and Describe the Initial Steps
in the Accounting Cycle

The accounting cycle is a step-by-step process to record

business activities and events to keep financial records
up to date. The process occurs over one accounting
period, and the cycle will begin again in the following
period. A period is one operating cycle of a business,
which could be a month, quarter, or year.

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Figure 3.5

The entire cycle is meant

to keep financial data
organized and easily
accessible to both
internal and external
users of information.

The Accounting Cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
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Figure 3.6

The first four steps of the accounting cycle are:

This takes information This takes analyzed Posting takes all This takes information
from original sources data from Step 1 and transactions from the from the general
or activities and organizes it into a journal during a period ledger and transfers it
translates that comprehensive record and moves the onto a document
information into usable of every company information to a showing all account
financial data. transaction. general ledger. balances, and ensures
debits = credits.

Accounting Cycle. The first four steps in the accounting cycle. Modified for PPT. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)
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Figure 3.7: Sample General Journal (Used in Step 2)
The general journal will contain a chronological listing of transactions.
A transaction is a business activity or event that has an effect on
financial information presented on financial statements and comes
from an original source. The journal is where a company can find a
record of all transactions that occurred during a given time period,
such as a day.

General Journal. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

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Figure 3.8: Sample General Ledger in T-Account Form
(Used in Step 3)

The general ledger provides a record of transactions for each individual

account in chronological order within that account. The ledger is where
a company will find the balance for a specific account. These account
balances will make up the trial balance created in Step 4.

General Ledger in T-Account Form. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

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Figure 3.9: Sample Trial Balance (Created in Step 4)

The trial balance

will include all
account balances.
Those balances will
come from the
general ledger.

Unadjusted Trial Balance. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
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Module 3.4 Analyze Business Transactions Using the
Accounting Equation and Show the Impact of Business
Transactions on Financial Statements

The first step in the accounting cycle is to identify and analyze

transactions.
Each original source must be evaluated for financial implications.
Meaning, will the information contained on this original source affect
the financial statements? If the answer is yes, the company will then
analyze the information for how it affects the financial statements.
One task is to determine the value of the transaction; sometimes this
is obvious, and others times it is less clear.

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Recording Transactions: Understanding
Impact on the Accounting Equation

Transaction 1: Issues $20,000 shares of common stock for cash.

Analysis: Cash is an asset and common stock is stockholder’s equity. When a

company collects cash, this will increase assets because cash is coming into the
business. When a company issues common stock, this will increase a stockholder’s
equity because he or she is receiving investments from owners.

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Transaction 2: Purchases equipment on account for $3,500, payment
due within the month.

Analysis: Equipment is an asset. There is an increase to assets because the

company has equipment it did not have before. We also know that the company
purchased the equipment on account, meaning it did not pay for the equipment
immediately and asked for payment to be billed instead and paid later—this is a
liability, specifically labeled as accounts payable. There is also an increase to
liabilities because the company now owes money.

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Transaction 3: Receives $4,000 cash in advance from a customer for
services not yet rendered.

Analysis: We know that the company collected cash, which is an asset. This
collection of $4,000 increases assets because money is coming into the business.

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Transaction 4: Provides $5,500 in services to a customer who asks to
be billed for the services.

Analysis: The company performed a service and therefore earned revenue.

However, the customer asked to be billed for the service, meaning the customer
did not pay with cash immediately. The customer owes money and has not yet
paid, signaling an accounts receivable. Accounts receivable is an asset that is
increasing in this case.

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Transaction 5: Pays a $300 utility bill with cash.

Analysis: The company paid with cash, an asset. Assets are decreasing by $300
since cash was used to pay for this utility bill. The company no longer has that
money.

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Transaction 6: Distributed $100 cash in dividends to stockholders.

Analysis: The company paid the distribution with cash, an asset. Assets decrease by
$100 as a result. Dividends affect equity and, in this case, decrease equity by $100.

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All six transactions summarized:

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Module 3.5 Use Journal Entries to Record
Transactions and Post to T-Accounts
Accountants use special forms called journals to keep track of their business
transactions. A journal is the first place information is entered into the
accounting system.
• Formatting when recording journal entries:
• Include a date of when the transaction occurred.
• The debit account title(s) always come first and on the left.
• The credit account title(s) always come after all debit titles are entered, and on the right.
• The titles of the credit accounts will be indented below the debit accounts.
• You will have at least one debit (possibly more).
• You will always have at least one credit (possibly more).
• The dollar value of the debits must equal the dollar value of the credits or else the equation
will go out of balance.
• You will write a short description after each journal entry.
• Skip a space after the description before starting the next journal entry.
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 Debit Accounts First

Date

Credit Accounts Indented Description

Dollar Values of Debits
Equal Dollar Values of
Credits

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A compound entry is when there is more than one account listed
under the debit and/or credit column of a journal entry.

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Putting the First Three Steps of the Accounting Cycle Together

Printing Plus, Inc. had the following transactions for the month of January:
1. On January 3, 2019, issues $20,000 shares of common stock for cash.
2. On January 5, 2019, purchases equipment on account for $3,500, payment due within the month.
3. On January 9, 2019, receives $4,000 cash in advance from a customer for services not yet rendered.
4. On January 10, 2019, provides $5,500 in services to a customer who asks to be billed for the services.
5. On January 12, 2019, pays a $300 utility bill with cash.
6. On January 14, 2019, distributed $100 cash in dividends to stockholders.
7. On January 17, 2019, receives $2,800 cash from a customer for services rendered.
8. On January 18, 2019, paid in full, with cash, for the equipment purchase on January 5.
9. On January 20, 2019, paid $3,600 cash in salaries expense to employees.
10. On January 23, 2019, received cash payment in full from the customer on the January 10 transaction.
11. On January 27, 2019, provides $1,200 in services to a customer who asks to be billed for the services.
12. On January 30, 2019, purchases supplies on account for $500, payment due within three months.

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Step 1: Record the Transactions in the General Journal
Transaction 1: On January 3, 2019, issues $20,000 shares of common stock for cash.

Analysis: Cash, an asset, increases and Common Stock, an equity, increases.

Financial Statement Impact:

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Transaction 2: On January 5, 2019, purchases equipment on account for $3,500,
payment due within the month.

Analysis: Equipment, an asset, increases and Accounts Payable, a liability, increases.

Financial Statement Impact:

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Transaction 3: On January 9, 2019, receives $4,000 cash in advance from a customer
for services not yet rendered.

Analysis: Cash, an asset, increases and Unearned Revenue, a liability, increases.

Financial Statement Impact:

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Transaction 4: On January 10, 2019, provides $5,500 in services to a customer who
asks to be billed for the services.

Analysis: Accounts Receivable, an asset, increases and Service Revenue, which

positively impacts equity, increases.
Financial Statement Impact:

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Transaction 5: On January 12, 2019, pays a $300 utility bill with cash.

Analysis: Cash, an asset, decreases and Utility Expense, which negatively impacts
equity, increases.
Financial Statement Impact:

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Transaction 6: On January 14, 2019, distributed $100 cash in dividends to
stockholders.

Analysis: Cash, an asset, decreases and Dividends, which negatively impacts equity,
increases.
Financial Statement Impact:

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Transaction 7: On January 17, 2019, receives $2,800 cash from a customer for
services rendered.

Analysis: Cash, an asset, increases and Service Revenue, which positively impacts
equity, increases.
Financial Statement Impact:
Assets = Liabilities + Stockholders’ Equity
+$2,800 0 + +$2,800

+$2,800 0 + +$2,800

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Transaction 8: On January 18, 2019, paid in full, with cash, for the equipment
purchase on January 5.

Analysis: Cash, an asset, decreases and Accounts Payable, a liability, decreases.

Financial Statement Impact:

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Transaction 9: On January 20, 2019, paid $3,600 cash in salaries expense to
employees.

Analysis: Cash, an asset, decreases and Salaries Expense, which negatively impacts
equity, increases.
Financial Statement Impact:

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Transaction 10: On January 23, 2019, received cash payment in full from the
customer on the January 10 transaction.

Analysis: Cash, an asset, increases and Accounts Receivable, an asset, decreases.

Financial Statement Impact:

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Transaction 11: On January 27, 2019, provides $1,200 in services to a customer who
asks to be billed for the services.

Analysis: Accounts Receivable, an asset, increases and Service Revenue, which

positively impacts equity, increases.
Financial Statement Impact:

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Transaction 12: On January 30, 2019, purchases supplies on account for $500,
payment due within three months.

Analysis: Supplies, an asset, increases and Accounts Payable, a liability, increases.

Financial Statement Impact:

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All the transactions as
they would appear,
chronologically, in the
general journal

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Step 2: Posting Transactions from General Journal to the General Ledger

Posting example:
The January 3 entry
entered in the journal
is shown here, posted
to the general ledger
accounts for Cash and
Common Stock.

Each account will

show the current
balance.

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These are all the
transactions recorded in the
journal during the month of
January that affected the
cash account.

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The cash transactions from the journal would be posted to
the Cash account in the ledger.

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Running Balance

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Determining Account Balance Using T-Accounts
Using the same transactions:
Transaction 1: On January 3, 2019, issues $20,000 shares of common stock for cash.

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Transaction 2: On January 5, 2019, purchases equipment on account for $3,500,
payment due within the month.

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 Transaction 3: On January 9, 2019, receives $4,000 cash in advance from a customer
for services not yet rendered.

Notice the entry

from Jan. 3, still
appears in the T-
account.

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Transaction 4: On January 10, 2019, provides $5,500 in services to a customer who
asks to be billed for the services.

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Transaction 5: On January 12, 2019, pays a $300 utility bill with cash.

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Transaction 6: On January 14, 2019, distributed $100 cash in dividends to
stockholder.

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Transaction 7: On January 17, 2019, receives $2,800 cash from a customer for
services rendered.

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Transaction 8: On January 18, 2019, paid in full, with cash, for the equipment
purchase on January 5.

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Transaction 9: On January 20, 2019, paid $3,600 cash in salaries expense to
employees.

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Transaction 10: On January 23, 2019, received cash payment in full from the
customer on the January 10 transaction.

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Transaction 11: On January 27, 2019, provides $1,200 in services to a customer who
asks to be billed for the services.

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Transaction 12: On January 30, 2019, purchases supplies on account for $500,
payment due within three months.

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Figure 3.10

Summary of T-Accounts for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
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Module 3.6 Prepare a Trial Balance (Step 4)

The trial balance is prepared from the general ledger.

Each account balance is listed by title and with its
current balance in the appropriate debit or credit
column. The total of all the amounts in the debit
column should equal the total amount in the credit
column.

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Connection Between Ledger Account
Balances and the Trial Balance

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The Final Unadjusted Trial Balance

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Summary
• The Financial Accounting Standards Board (FASB) is an independent, nonprofit organization that sets
the standards for financial accounting and reporting standards for both public- and private-sector
businesses in the United States, including generally accepted accounting principles (GAAP).
• GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial
statements.
• The Securities and Exchange Commission (SEC) is an independent federal agency that is charged
with protecting the interests of investors, regulating stock markets, and ensuring companies adhere
to GAAP requirements.
• The FASB uses a conceptual framework, which is a set of concepts that guide financial reporting.
• The expanded accounting equation breaks down the equity portion of the accounting equation into
more detail to show common stock, dividends, revenue, and expenses individually.
• The chart of accounts is a numbering system that lists all of a company’s accounts in the order in
which they appear on the financial statements, beginning with the balance sheet accounts and then
the income statement accounts.
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Summary (continued)
• Step 1 in the accounting cycle: Identifying and analyzing transactions requires a company to
take information from an original source, identify its purpose as a financial transaction, and
connect that information to an accounting equation.

• Step 2 in the accounting cycle: Recording transactions to a journal takes financial

information identified in the transaction and copies that information, using the accounting
equation, into a journal. The journal is a record of all transactions.

• Step 3 in the accounting cycle: Posting journal information to a ledger takes all information
transferred to the journal and posts it to a general ledger. The general ledger in an
accumulation of all accounts a company maintains and their balances.

• Step 4 in the accounting cycle: Preparing an unadjusted trial balance requires transfer of
information from the general ledger (T-accounts) to an unadjusted trial balance showing all
account balances. The trial balance contains a listing of all accounts in the general ledger
with nonzero balances. Information is transferred from the T-accounts to the trial balance.
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This OpenStax ancillary resource is © Rice University under a CC-BY-NC-
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noncommercial purposes only but must be attributed to OpenStax,
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