Chapter 2
Establishing a Business and Establishing a Business and the Balance Sheetthe Balance Sheet
© 2009 The McGraw-Hill Companies, Inc.
Slide 2Slide 2
The Nature of Business Transactions
External Events
Exchanges between the business and others involving
the exchange of assets and services from one company for other assets or promises
to pay from another company.
Internal Events
Certain events that are not exchanges between the
business and others, but which have a direct and measurable effect on the
entity.
Slide 3Slide 3
Account Number Account Name Description
101 Cash amount of coins, paper money, and funds in the bank
104 Investments amount of excess cash invested in stocks, bonds, certificates of deposit, etc.
106 Accounts Receivable
amounts owed by customers buying goods or services on account
107 Notes Reveivable signed promises to pay by customers, employees, and others
110 Inventories goods to be sold
115 Supplies pencils, boxes, paper, etc. to be used in future periods
120 Prepaid Rent amount paid to rent buildings and equipment in future periods
121 Prepaid Insurance amount paid to receive insurance coverage in future periods
122 Prepaid Advertising
amount paid to advertise in future periods
140 Equipment trucks, machinery, computers, etc. to be used in future periods
145 Buildings structures acquired to use in future periods
160 Land real estate property acquired to use in future periods
180 Intangible Assets long-term rights such as patents and trademarks
201 Accounts Payable amounts owed to suppliers due to buying goods or services on account
205 Wages (or Salaries) Payable
amounts owed to employees for work in past periods
210 Notes Payable signed promise by the company from borrowing money
217 Interest Payable amount due on notes payable as the cost of borrowing
230 Unearned Revenue
amount received from customers in advance of delivering goods or services to them
300 "Owner's Name," Capital
amount of equity owner has in the business
Chart of Accounts (partial - balance sheet accounts only)
Each company
establishes a chart of
accounts—a list of all the
account titles and
their numbers that are
unique to each
company.
Slide 4Slide 4
Transaction Analysis
Two simple ideas are used when analyzing transactions:
Duality of Effects
Every transaction affects at least two accounts.
Balancing the Equation
Assets = liabilities + owner’s equity must remain in balance.
Slide 5Slide 5
Dual Effects
Pay cash for supplies.
Duality of Effects
1. Pizza Aroma receives Supplies.
2. Pizza Aroma gives Cash.
Balancing the Equation
Supplies (an asset) increases.
Cash (an asset) decreases.
Supplies (an asset) increases
Cash (an asset) decreases
Slide 6Slide 6
Balancing the Accounting Equation
Pay cash for supplies.
Assets = Liabilities + Owner's Equity+ Supplies No change No change
- Cash
Duality of Effects
1. Pizza Aroma receives Supplies.
2. Pizza Aroma gives Cash.
Balancing the Equation
Supplies (an asset) increases.
Cash (an asset) decreases.
Slide 7
Identify the
accounts affected.
Classify them by
the type of account.
Determine the
direction of the effect.
Step 1
Verify that the accounting equation remains in balance.
Step2
Transaction Analysis Steps
Slide 8
Analysis of Pizza Aroma’s Transactions
(a) Investment by Owner. The business receives $30,000 cash as an initial investment from owner-manager, Mauricio Rosa.
Step 1: Identify and classify accounts and effects:
Received: Cash (+A) $30,000.
Given: Recognition of owner’s investment in the business.
M. Rosa, Capital (+OE) $30,000.
Step 2: Is the accounting equation in balance?
Yes. The left side increased by $30,000 and the right side
increased by $30,000.
= +Owner's Equity
Cash Investments SuppliesPrepaid
Rent EquipmentAccounts Payable
Notes Payable
M. Rosa, Capital
(a) 30,000 30,000
Assets Liabilities
Slide 9
Analysis of Pizza Aroma’s Transactions
(b) Borrow from Bank. Pizza Aroma obtains a $20,000 loan from a local bank.
Step 1: Identify and classify accounts and effects:
Received: Cash (+A) $20,000.
Given: A written promise by the business to pay the bank.
Notes Payable (+L) $20,000.
Step 2: Is the accounting equation in balance?
Yes. The left side increased by $20,000 and the right side
increased by $20,000.
= +Owner's Equity
Cash Investments SuppliesPrepaid
Rent EquipmentAccounts Payable
Notes Payable
M. Rosa, Capital
(b) 20,000 20,000
Assets Liabilities
Slide 10
Analysis of Pizza Aroma’s Transactions
(c) Prepaid Rent. Pizza Aroma pays $4,800 in advance to the building owner to cover rent for the store for May through October (six months).
Step 1: Identify and classify accounts and effects:
Received: Prepaid Rent (+A) $4,800.
Given: Cash (-A) $4,800.
Step 2: Is the accounting equation in balance?
Yes. The left side increased and decreased by the same amount
($4,800).
= +Owner's Equity
Cash Investments SuppliesPrepaid
Rent EquipmentAccounts Payable
Notes Payable
M. Rosa, Capital
(c) (4,800) 4,800
Assets Liabilities
Slide 11
Analysis of Pizza Aroma’s Transactions
(d) Purchase Equipment. A construction company renovates the store and installs equipment at a cost of $36,000; $33,000 in cash is paid and Pizza Aroma promises to pay the balance next month.
Step 1: Identify and classify accounts and effects:
Received: Equipment (+A) $36,000.
Given: Cash (-A) $33,000, anda promise to pay,
Accounts Payable (+L) $3,000.
Step 2: Is the accounting equation in balance?
Yes. The left side increased by $3,000 ($36,000 - $33,000) and the
right side increased by $3,000.
= +Owner's Equity
Cash Investments SuppliesPrepaid
Rent EquipmentAccounts Payable
Notes Payable
M. Rosa, Capital
(d) (33,000) 36,000 3,000
Assets Liabilities
Slide 12
Analysis of Pizza Aroma’s Transactions
(e) Purchase Supplies. Pizza Aroma orders and receives $2,000 in supplies on account from local fresh food suppliers.
Step 1: Identify and classify accounts and effects:
Received: Supplies(+A) $2,000.
Given: A promise to pay.Accounts Payable (+L) $2,000.
Step 2: Is the accounting equation in balance?
Yes. The left side increased by $2,000 and the right side increased
by $2,000.
= +Owner's Equity
Cash Investments SuppliesPrepaid
Rent EquipmentAccounts Payable
Notes Payable
M. Rosa, Capital
(e) 2,000 2,000
Assets Liabilities
Slide 13
Analysis of Pizza Aroma’s Transactions
(f) Pay Account Owed to Supplier. Pizza Aroma pays $1,000 cash on account to a supplier.
Step 1: Identify and classify accounts and effects:
Received: A reduction in the amount owed to the supplier.Accounts Payable (-L) $1,000.
Given: Cash (-A) $1,000.
Step 2: Is the accounting equation in balance?
Yes. The left side decreased by $1,000 and the right side
decreased by $1,000.
= +Owner's Equity
Cash Investments SuppliesPrepaid
Rent EquipmentAccounts Payable
Notes Payable
M. Rosa, Capital
(f) (1,000) (1,000)
Assets Liabilities
Slide 14
Analysis of Pizza Aroma’s Transactions
(g) Acquire Investments. Pizza Aroma puts $6,000 in a savings account at a bank.
Step 1: Identify and classify accounts and effects:
Received: Investments(+A) $6,000.
Given: Cash (-A) $6,000.
Step 2: Is the accounting equation in balance?
Yes. The left side increased and decreased by the same amount
($6,000).
= +Owner's Equity
Cash Investments SuppliesPrepaid
Rent EquipmentAccounts Payable
Notes Payable
M. Rosa, Capital
(g) (6,000) 6,000
Assets Liabilities
Slide 15
Analysis of Pizza Aroma’s Transactions
= +Owner's Equity
Cash Investments SuppliesPrepaid
Rent EquipmentAccounts Payable
Notes Payable
M. Rosa, Capital
(a) 30,000 30,000 (b) 20,000 20,000 (c) (4,800) 4,800 (d) (33,000) 36,000 3,000 (e) 2,000 2,000 (f) (1,000) (1,000) (g) (6,000) 6,000
Totals 5,200 6,000 2,000 4,800 36,000 4,000 20,000 30,000
Assets Liabilities
$54,000 $54,000
Slide 16
The Accounting Cycle
During the Period(Chapters 2 and 3)
1.Analyze transactions2.Record journal entries in the general journal3.Post amounts to the general ledger
At the End of the Period(Chapter 4)
4.Adjust revenues and expenses and related balance sheet accounts5.Prepare a complete set of financial statements and disseminate it to users6.Close revenues, gains, expenses, and losses to owner’s equity
Start of New Period
Slide 17
Analyzing Business Transactions
= ++ - - + - +
debit credit debit credit debit credit
Assets Liabilities Owner's Equity
Withdrawals by owners decrease owner’s equity.
Investments by owners
and net income of business increase owner’s equity.
Slide 18
Analyzing Business Transactions
= ++ - - + - +
debit credit debit credit debit credit
Assets Liabilities Owner's Equity
Debit = Left Credit = Right
Withdrawals by owners decrease owner’s equity.
Investments by owners
and net income of business increase owner’s equity.
Slide 19
Recording Transaction Effects
Date Account Titles and Explanation Ref. Debit Credit
May 1 30,000
30,000
May 2 20,000
20,000
May 5 36,000
Cash 33,000
3,000
Notes Payable
(Borrowed from bank.)
Equipment
Accounts Payable(Purchased equipment paying part cash and the rest on credit.)
Cash
M. Rosa, Capital
(Investment by owner.)
Cash
General Journal Page G1
Slide 20
Recording Transaction Effects
Event Debit Credit
(d) 36,000
Cash (-A) 33,000
3,000
Account Titles
Equipment (+A)
Accounts Payable (+L)
Slide 21
Posting Transaction EffectsAfter journal entries have
been recorded, the bookkeeper
posts (transfers) the dollar amounts to each ledger
page that is affected by the transaction, so
that the account
balances can be computed.
Ledger101
Date Explanation Ref. Debit Credit Balance
May 1 G1 30,000 30,000
May 2 G1 20,000 50,000
May 3 G1 4,800 45,200
May 5 G1 33,000 12,200
Cash
Event Debit Credit
May 5 36,000
Cash (-A) 33,000
3,000
Equipment (+A)
Accounts Payable (+L)
Account Titles
Slide 22
Posting Transaction Effects
The T-account is a simplified version of a
ledger page.
Ledger
Beg. -
(a) 30,000 4,800 (c)
(b) 20,000 33,000 (d)
End. 12,200
Debit (+) Credit (-)
Cash
Slide 23
Pizza Aroma’s Accounting Records
Using T-Accounts
Ledger Pages
General Journal
Journal Entries
Identify and classify
accounts
Transactions
(1) Analyze (2) Record (3) Post
Slide 24
Pizza Aroma’s Accounting Records
Assets = Liabilities + Owner's EquityCash + $30,000 No change M. Rosa, Capital +$30,000
(a) Investment by Owner. The business receives $30,000 cash as an initial investment from owner-manager, Mauricio Rosa.
Event Debit Credit
(a) 30,000
M. Rosa, Capital (+OE) 30,000
Cash (+A)
Account Titles
- Beg. 30,000 (a)30,000 Bal.
M. Rosa, CapitalBeg. -
(a) 30,000 Bal. 30,000
Cash
Slide 25
Pizza Aroma’s Accounting Records
Assets = Liabilities + Owner's EquityCash + $20,000 Notes Payable + $20,000 No change
Event Debit Credit
(b) 20,000
Notes Payable (+L) 20,000
Cash (+A)
Account Titles
Beg. - (a) 30,000 (b) 20,000
Bal. 50,000
Cash
- Beg. 20,000 (b)20,000 Bal.
Notes Payable
(b) Borrow from Bank. Pizza Aroma obtains a $20,000 loan from a local bank.
Slide 26
Pizza Aroma’s Accounting Records
Debit Credit
(a) 30,000
30,000
(b) 20,000
20,000
(c) Prepaid Rent (+A) 4,800
Cash (-A) 4,800
(d) 36,000
Cash (-A) 33,000
3,000
(e) Supplies (+A) 2,000
2,000
(f) 1,000
1,000
(g) Investments (+A) 6,000
6,000
Account Titles
Cash (+A)
M. Rosa, Capital (+OE)
Cash (+A)
Notes Payable (+L)
Equipment (+A)
Accounts Payable (+L)
Accounts Payable (-L)
Cash (-A)
Cash (-A)
Accounts Payable (+L)
Slide 27
Beg. - (a) 30,000 4,800 (c) (b) 20,000 33,000 (d)
1,000 (f)6,000 (g)
Bal. 5,200
Cash
Beg. - (e) 2,000
Bal. 2,000
Supplies
- Beg.(f) 1,000 3,000 (d)
2,000 (e)4,000 Bal.
Accounts Payable
- Beg.20,000 (b)20,000 Bal.
Notes Payable- Beg.
30,000 (a)30,000 Bal.
M. Rosa, Capital
Beg. - (d) 36,000
Bal. 36,000
Equipment
Beg. - (g) 6,000
Bal. 6,000
Investments
Beg. - (g) 4,800
Bal. 4,800
Prepaid Rent
Slide 28
Preparing a Trial Balance
Debit CreditCash 5,200$ Investments 6,000 Supplies 2,000 Prepaid Rent 4,800 Equipment 36,000 Accounts Payable 4,000$ Notes Payable 20,000 Mauricio Rosa, Capital 30,000 Total 54,000$ 54,000$
Pizza AromaTrial Balance
On May 7
Slide 29
Locating and Correcting Errors
Possible Errors 1.Totaling the debit and credit columns in the trial balance.2.Copying the ending balances from the T-accounts to the trial balance.3.Computing the ending balances in the T-accounts.4.Incorrectly posting the dollar effects of a transaction from the journal entry to the T-accounts.5.Preparing journal entries in which the debits do not equal the credits.
Slide 30
Classified Balance Sheet
Current AssetsCash 5,200$ Investments 6,000 Supplies 2,000 Prepaid Rent 4,800 Total current assets 18,000 Equipment 36,000 Total Assets 54,000$
Current LiabilitiesAccounts payable 4,000$ Total current liabilities 4,000 Notes Payable 20,000 Total Liabilities 24,000
M. Rosa, Capital 30,000 Total Liabilities and Owner's Equity 54,000$
Pizza Aroma
Balance Sheet
May 7, 2009
Assets
Liabilities
Owner's Equity
Current assets will be used or turned into cash within one
year.
Noncurrent assets are expected to last for several
years.
Current liabilities will need to be paid or settled within the
coming year.
Noncurrent liabilities are owed beyond one year.
Slide 31
Limitations of the Balance Sheet
What is (and is not) recorded?
What amounts are assigned to recorded
items?
Cost Principle Conservatism
Slide 32
Summary of the Accounting Cycle
During the Period(Chapters 2 and 3)
1.Analyze transactions2.Record journal entries in the general journal3.Post amounts to the general ledger
At the End of the Period(Chapter 4)
4.Adjust revenues and expenses and related balance sheet accounts5.Prepare a complete set of financial statements and disseminate it to users6.Close revenues, gains, expenses, and losses to owner’s equity
Start of New Period
Slide 33Slide 33
Supplement 2-A: Accounting Concepts Revisited
Qualitative Characteristics
Relevancy
Reliability
Comparability
Consistency
Qualitative Characteristics
Relevancy
Reliability
Comparability
Consistency
Elements of Statements
Asset
Liability
Owner’s Equity
Revenue
Expense
Elements of Statements
Asset
Liability
Owner’s Equity
Revenue
Expense
Objective of Financial Reporting
To provide useful economic information to external users for decision making.
Objective of Financial Reporting
To provide useful economic information to external users for decision making.
Primary Characteristics• Relevancy: predictive value, feedback value, and timeliness.• Reliability: verifiability, representational faithfulness, and neutrality.
Secondary Characteristics• Comparability: across companies.• Consistency: over time.
Slide 34Slide 34
Supplement 2-A: Accounting Concepts Revisited
AssumptionsSeparate entityUnit-of-measure
ContinuityTime Period
AssumptionsSeparate entityUnit-of-measure
ContinuityTime Period
PrinciplesHistorical cost
Revenue RecognitionMatching
Full Disclosure
PrinciplesHistorical cost
Revenue RecognitionMatching
Full Disclosure
ConstraintConservatism
Slide 35
End of Chapter 2