Downloadable Solution Manual for Financial Accounting Second Canadian Edition 2nd Edition Harrison harrison fa 2ce irm ch0214

CHAPTER 2 Processing Accounting Information CHAPTER OVERVIEW Chapter 2 introduces the processing of accounting informat...

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CHAPTER 2 Processing Accounting Information

CHAPTER OVERVIEW Chapter 2 introduces the processing of accounting information by first defining terms and describing transactions and specific asset, liability, and shareholders’ equity accounts. A variety of business transactions are analyzed and recorded by using the accounting equation; the effects of these transactions on the financial statements are shown. The three financial statements that result from these transactions are presented and linked together. A mid-chapter summary problem includes both analysis of transactions and the preparation of all four financial statements for a service corporation. The concept of double-entry bookkeeping and the rules of debit and credit for assets, liabilities, and shareholders’ equity are described. The “T-account” is illustrated. After the terms debit and credit are defined, students learn how the accounting equation is tied to the rules of debit and credit. The journal is introduced; the process of recording transactions (journalizing) is illustrated as a three-step process. The ledger and the posting process are explained. Students examine a series of entries as they are analyzed, journalized, and posted to T-accounts in the ledger. Next the chapter presents the purpose and preparation of the trial balance. Some of the possible accounting errors that may be revealed by a trial balance are described, and students learn how to correct these errors. A chart of accounts is illustrated, and the normal balances of accounts are explained. The three-column account format is illustrated. Decision Guidelines are presented that assist the student in analyzing and recording transactions. A journal entry may be quickly analyzed, without using a journal, by looking directly to the effect of that transaction on the ledger accounts. The chapter concludes with a summary problem that reviews opening accounts, journalizing, posting, preparing a trial balance, and preparing an income statement.

LEARNING OBJECTIVES After studying Chapter 2, your students should be able to: 1.

Analyze business transactions

2.

Understand how accounting works

3.

Record business transactions

4.

Use a trial balance

5.

Analyze transactions for quick decisions

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SUGGESTED PRIORITY OF CHAPTER TOPICS MUST COVER • • • • • • •

Terminology and description of accounts Analysis of transactions Double-entry accounting Rules of debit and credit and the normal balances of accounts Journal entries Posting Trial balance

RECOMMENDED • •

Chart of accounts Quick decision making

IF TIME PERMITS • •

Correcting errors Three-column format of an account

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CHAPTER OUTLINE OBJECTIVE 1: Analyze business transactions

A transaction is any event that has a financial impact on the business and can be measured reliably. A.

Account – a basic component of an accounting system. The account, a basic summary device, shows all the increases and decreases in a particular asset, liability, or shareholders’ equity. Accounts are grouped based on the accounting equation, A = L + SHE.

B.

Assets – economic resources that benefit a business now, or will be of benefit to the business in the future. Cash, receivables, inventory, prepaid expenses, land, building, furniture, and equipment are examples of assets.

C.

Liabilities – debts or other obligations of the business that must be satisfied in the future. Accounts and notes payable, salary payable, taxes payable, interest payable, and other accrued expenses are all examples of liabilities.

Teaching Tip As students begin to use many different accounts, remind them that a receivable is always an asset because it represents an amount that will be received in the future and a payable is always a liability because it represents an amount that will be paid in the future. Explain that receivables often are related to customers while payables often are related to vendors. D.

Shareholders’ Equity – owners’ (investors’) claims on assets owned by the corporation. Contributed capital, retained earnings, dividends, revenues, and expenses are all shareholders’ equity accounts. Another similar term is “owners’ equity.”

E.

Revenues – income earned from performing services or selling products. Revenues increase net income and retained earnings and thus increase shareholders’ equity.

F.

Expenses – costs incurred in operating a business. Expenses decrease net income and retained earnings and decrease shareholders’ equity, which is just the opposite effect of revenues.

G.

A business transaction is an event that affects the financial position of a business and may be reliably recorded.

H.

Business transactions are analyzed according to their effect on the accounting equation. The accounting equation must balance after each transaction is recorded.

I.

Exhibit 2-1 illustrates how the following 11 transactions affect the equation:

Teaching Tip The purpose of Exhibit 2-1 is to help students identify the accounts involved in each transaction and to determine whether those accounts increase or decrease. The second part of the chapter will illustrate the actual recording process for these transactions.

1.

Owners’ investment of cash increases both assets and shareholders’ equity.

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2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Purchase of an asset for cash increases assets and decreases assets (no effect on total assets). Purchase of an asset on credit (on account) increases both assets and liabilities. Receipt of cash for service revenue increases both assets and shareholders’ equity. Performance of services on account increases both assets and shareholders’ equity. Cash payment of expenses decreases both assets and shareholders’ equity. Payment on account decreases both assets and liabilities. Personal transactions of the owner do not affect the business, per the entity concept. Collection of cash on account increases assets and decreases assets. Sale of an asset at a price equal to its cost increases assets and decreases assets. Declaration and payment of cash dividends decreases both assets and shareholders’ equity.

Teaching Tip Help students see the difference in the four ways “on account” is used in the above transactions: 1. Performed services on account means Accounts Receivable increases 2. Collected on account means Accounts Receivable decreases 3. Purchased on account means Accounts Payable increases 4. Paid on account means Accounts Payable decreases J.

Exhibit 2-2 illustrates three financial statements that are prepared from the transactions in the previous exhibit. Arrows link the data that flow from statement to statement. 1. The income statement reports net income or net loss for the period (revenues minus expenses equals net income; if expenses exceed revenues, a net loss is reported). 2. The statement of retained earnings reports the change in retained earnings for the period, including both net income (from the income statement) and dividends. 3. The balance sheet reflects the accounting equation at the end of the period, proving that assets = liabilities + shareholders’ equity. Included in the shareholders’ equity section of the balance sheet is ending retained earnings (from the statement of retained earnings). The fourth financial statement, the cash flow statement, is not presented. It reports all cash receipts and disbursements for the period. Ending cash on the statement is the same as cash on the balance sheet.

Teaching Tip The equations that describe each financial statement can be very helpful to students struggling to understand how one financial statement differs from another. It is useful to draw a diagram which represents the three statements on the board with two balance sheets (beginning and ending and linking it down to Income statement and statement of retained earnings between I/S and ending B/S) Income Statement: Revenues – Expenses = Net Income (or loss) Statement of Retained Earnings: bbRetained Earnings + Net Income – Dividends = ebRetained Earnings (where bb and eb stand for beginning balance and ending balance respectively) Balance Sheet: Assets = Liabilities + Shareholders’ Equity K.

Because of the entity concept, the business will include neither personal transactions of the owners nor transactions of other businesses on its financial statements.

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OBJECTIVE 2: Understand how accounting works A.

Accounting is a double-entry system that reports the dual effects, giving and receiving, of all business transactions. Each transaction affects at least two accounts.

B.

The T-account is an abbreviated form of an account, used to help illustrate the effect of transactions. Account Name Debit entries Credit entries (left side) (right side)

Teaching Tip A T-account is a quick way to show the effect of transactions on a particular account -- a useful shortcut in accounting. C.

The type of account determines the side on which increases and decreases are recorded; the rules of debit and credit keep the accounting equation in balance.

Teaching Tip Students must forget anything they might be thinking about debits and credits, such as terminology used on a bank statement. They must memorize this rule: Debit = left side of an account Credit = right side of an account Debit and credit signify directions -- debit for left and credit for right. Draw a diagram on the board showing the T-Account for assets and show the debit/credit. Then indicate the liabilities and equities are just a mirror image of the asset. This also re-emphasizes the balance sheet equation. 1. 2.

Increases in assets are recorded on the left (debit) side of the account. Decreases in assets are recorded on the right (credit) side. Rules for liabilities and shareholders’ equity accounts are the opposite of the rules for assets. Increases in liabilities and shareholders’ equity accounts are recorded on the right (credit) side of an account, and decreases are recorded on the left (debit) side.

D.

Summaries of the rules of debit and credit are found in Exhibits 2-3 and 2-6. Assets, liabilities, and shareholders’ equity are listed first in Exhibit 2-3, and then retained earnings, dividends, revenues, and expenses are added in Exhibit 2-6.

E.

Double-entry bookkeeping and the rules of debit and credit are based on the accounting equation, A = L + SHE. After each transaction is recorded, the equation must remain in balance, as illustrated in Exhibit 2-4.

Teaching Tip Every transaction involves both a debit and a credit, and the total amount debited in a transaction must always equal the total amount credited. F.

After increases and decreases in an account are recorded, the amount remaining in the account is its balance. All account balances are computed by adding the beginning balance and the increases, and subtracting the decreases. (The balance equals the difference between total debit entries and total credit entries.)

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G.

Exhibit 2-5 illustrates the expanded accounting equation, including assets, liabilities, and all types of shareholders’ equity accounts.

OBJECTIVE 3: Record business transactions A.

Transactions are recorded first in the journal, a chronological listing of all the entity’s business transactions.

B.

Analysis of each transaction involves these steps: 1. Identify the transaction from the source document, such as a sales invoice or check stub. a. Specify each account affected b. Classify each account by type such as asset or expense 2. For the accounts involved a. Determine which accounts increase and which decrease. (Some transactions may require only increases or only decreases.) b. Apply the rules of debit and credit 3. Enter the transaction in the journal, listing first the debit and then the credit. Verify that total debits equal total credits. A journal entry would appear as follows: Account Name XX (debit amount) Account Name XX (credit amount) Brief explanation of the transaction.

Teaching Tip A logical sequence of steps must be followed when recording transactions: analyze (determine the accounts affected and whether the accounts increase or decrease), apply rules of debit and credit, journalize the entry, and include an explanation. It may be helpful to explain the journal entry process to students in the form of the following set of questions they can ask themselves (and hopefully answer) for each identified transaction: • What accounts are involved? • For each account: What kind of account is it? (asset, liability, revenue, expense, or “other”) Is that account increasing or decreasing as a result of the transaction? How do I increase (or decrease) this kind of account? (apply the rules of debit and credit)

C.

The journal gives more information than a ledger account provides because it shows the complete effect of each transaction, not just one part of it.

D.

The journal entry should always include a brief explanation of the transaction.

E.

Ledger – a group of accounts. All the accounts of a business grouped together form a book called the ledger (or general ledger). 1. Exhibit 2-7 shows how accounts are grouped in the ledger. 2. The correct order of accounts is assets, liabilities, then shareholders’ equity.

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Teaching Tip Ask students, Why do we use two records, the journal and the ledger? Businesses need both a chronological record of transactions (the journal) and a record of each account’s activity and its balance (the ledger). Both are necessary to ensure that data are reported accurately. You can also discuss the role of the auditor here and the requirements from a tax standpoint to maintaining adequate and complete records. F.

Posting – the process of copying (transferring) data from the journal to accounts in the ledger. 1. Debits in the journal are posted as debits to the appropriate accounts; credits in the journal are posted as credits to the appropriate accounts. 2. All transactions must be keyed by date or number to provide a link between the journal and the ledger. (Exhibits 2-8 and 2-9 illustrate the flow of accounting information, from journalizing the original entry to posting it to the accounts in the ledger.) 3. Exhibit 2-10 shows how ledger accounts appear after a series of transactions have been posted and account balances calculated.

OBJECTIVE 4: Use a trial balance A.

The trial balance is a listing, in general ledger order (assets, liabilities, then shareholders’ equity), of the debit or credit balance in each account. (Refer to Exhibit 2-11.)

Teaching Tip Make sure that students understand that the trial balance is not one of the four financial statements, but merely a tool to aid the accountant in the preparation of the financial statements. You may also want to point out that the kinds of errors detected by a trial balance are the kinds of errors that humans make frequently but computers make very infrequently. B.

Unequal column totals indicate at least one error. Some common errors are: 1. Posting incorrectly. 2. Mathematical errors. a. Transposition means digits are written in the wrong order. (For example, instead of $567, the number is written as $657.) A transposition error is always evenly divisible by 9 ($657 - $567 = $90, which is divisible by 9). b. A slide means that one or more zeroes are added to, or left off, a number ($1,000 is written as $100). A slide is always evenly divisible by 9. 3. Omitting or entering account balances in the wrong column of the trial balance.

C.

Equal trial balance totals prove only that debits posted to accounts equal credits posted to accounts; equal totals prove whether debit balances in the accounts equal credit balances. Errors in transactions that have equal debits and credits will not be revealed by unequal totals.

Teaching Tip Here is one way to look for possible errors on a trial balance. Have students refer to Exhibit 2-11. Assume that Dividends of $2,100 are erroneously listed in the credit column on the trial balance. Recalculate the trial balance totals. (Debit column = $56,500. Credit column = $60,700.) To find the mistake, calculate the difference between the column totals and divide that amount by two: $60,700 - $56,500 = $4,200; $4,200/2 = $2,100. Tell students that if they locate that amount on the trial balance, it is probably entered in the wrong column.

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D.

The chart of accounts lists all the accounts (in numerical order) and their account numbers. Exhibit 2-12 illustrates a chart of accounts. 1. Accounts are numbered beginning with assets, then liabilities, shareholders’ equity, revenues and finally expenses; accounts in the ledger are always in this same order. 2. The normal balance of an account is the side used to record increases; Exhibit 2-13 lists the normal balances for all types of accounts. 3. Often, a shift of a balance amount away from its normal column indicates there has been an accounting error made. 4. A three-column account format with a running balance is most often used in practice. (Refer to Exhibit 2-14.)

Teaching Tip The following “normal balance T-account” may be helpful to students in applying the rules of debit and credit. Normal Balances Assets

Liabilities

Expenses

Revenues

Dividends Common Shares Retained Earnings

Teaching Tip Every account balance is derived from four components: 1. Beginning balance 2. + Increases 3. - Decreases 4. = Ending balance For example, if cash at the beginning of the period is $2,000, cash receipts during the period total $26,000, and cash disbursements are $25,000, then ending cash is $3,000. If you know any three of the four components, you can calculate the fourth. You can also see these relationships by recording this information in a T-account for Cash. (You might further illustrate this for your students by drawing three additional T-accounts on the board and review the types of transactions that affect Accounts Receivable, Accounts Payable, and Retained Earnings; relate these accounts to the formula illustrated above.) E.

Decision Guidelines for analyzing and recording transactions are presented.

OBJECTIVE 5: Analyze transactions for quick decisions A.

A quick way to analyze a transaction is to skip the journal and look directly to its effect on the ledger; this is never done within the formal accounting system, but only when a fast analysis of transactions is required.

B.

To take this short cut, simply compress transaction analysis, journalizing, and posting into one step.

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ASSIGNMENT GRID

Assignment Topic(s) CP-1 CP-2 CP-3 CP-4 CP-5 CP-6 CP-7 CP-8 CP-9 CP-10 CP-11 CP-12 E2-1 E2-2 E2-3 E2-4 E2-5 E2-6 E2-7 E2-8 E2-9 E2-10 E2-11 E2-12 E2 13 E2-14 E2-15 E2-16 E2-17 P2-1A P2-2A P2-3A P2-4A P2-5A P2-6A P2-7A

Learning Objective(s)

Explaining an asset versus an expense 1 Analyzing the effects of transactions 1 Analyzing transactions 1 Analyzing transactions 1 Recording transactions 2,3 Journalizing transactions; posting 2,3 Journalizing transactions; posting 2,3 Preparing and using a trial balance 4 Using a trial balance 4 Using a trial balance 4 Using key accounting terms 2 Analyzing transactions without a journal 5 Reporting on business activities 1 Business transactions and the accounting equation 1 Transaction analysis 1 Transaction analysis; accounting equation 1 Journalizing transactions 2,3 Analyzing transactions 1 Journalizing transactions 2,3 Posting to the ledger and preparing and using a trial balance 3,4 Journalizing transactions 2,3 Preparing and using a trial balance 4 Correcting errors in a trial balance 4 Recording transactions without a journal 5 Preparing and using a trial balance 4 Recording transactions and preparing a trial balance 2,3,4 Computing financial statement amounts without a journal 5 Analyzing transactions; using a trial balance 1,4 Analyzing transactions 1 Analyzing a trial balance 1 Analyzing transactions with the accounting equation and preparing the financial statements 1 Recording transactions, posting 2,3 Analyzing transactions with the accounting equation 1,2 Analyzing and journalizing transactions 2,3 Journalizing transactions, posting and preparing and using a trial balance 2,3,4 Recording transactions directly T-accounts;

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Estimated Time in Minutes

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P2-1B P2-2B P2-3B P2-4B P2-5B P2-6B P2-7B Decision-1

Decision-2 Ethical Issues Financial Statement Analytical

preparing a trial balance 4,5 Analyzing a trial balance 1 Analyzing transactions with the accounting equation and preparing the financial statements 1 Recording transactions, posting 2,3 Analyzing transactions with the accounting equation 1,2 Analyzing and recording transactions 2,3 Journalizing transactions, posting and preparing a trial balance 2,3,4 Recording transactions directly T-accounts; preparing a trial balance 4,5 Recording transactions directly in T-accounts; preparing a trial balance, and measuring net income or loss 4,5 Correcting financial statements; deciding whether to expand a business 2 Recording transactions and computing net income Analyzing a leading company’s financial statements

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ANSWER KEY TO CHAPTER 2 QUIZ 1. C 2. B 3. A 4. B 5. A

6. A 7. C 8. D 9. C 10. B

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Name

Date

Section

CHAPTER 2 TEN-MINUTE QUIZ Circle the letter of the best response. 1. Which of these is (are) an example of a liability account? A. Service Revenue B. Prepaid Insurance C. Accounts Payable D. All of the above are liabilities 2.

Fredson Corporation received $27,500 on account from a previous sale. The effect of this transaction on Fredson’s accounting equation is to: A. decrease liabilities and increase shareholders’ equity. B. increase assets and decrease assets. C. increase assets and decrease shareholders’ equity. D. decrease assets and increase shareholders’ equity.

3.

Which of these statements is false? A. Decreases in liabilities and increases in revenues are recorded with a credit. B. Decreases in assets and increases in shareholders’ equity are recorded with a credit. C. Increases in both assets and expenses are recorded with a debit. D. Increases in assets and decreases in liabilities are recorded with a debit.

4.

Accounts Receivable has a normal beginning balance of $70,200. During the period, new sales on account total $50,000 and receipts from customers total $20,600. Determine the correct ending balance in Accounts Receivable. A. $40,800, debit B. $99,600, debit C. $40,800, credit D. $49,600, debit

5.

Which of these statements is correct? A. The account is a basic summary device used in accounting. B. A business transaction is recorded first in the ledger and then posted to the journal. C. In the journal entry, all accounts that are increased are listed first and then all accounts that are decreased are listed next. D. Both A and B are correct.

6.

Which of these accounts has a normal debit balance? A. Dividends B. Accounts Payable C. Service Revenue D. Both A and B

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7.

The May 31 trial balance reports a credit balance of $45,000 for Service Revenue. During the month, one entry for $1,500 had been posted in error as a debit, instead of as a credit, to Service Revenue. What is the correct balance of Service Revenue at May 31? A. $45,000 B. $42,000 C. $48,000 D. $46,500

8.

The beginning Inventory account balance is $78,700. During the period, inventory sold totaled $144,600. If ending Inventory is $61,200, then inventory purchases must have been: A. $223,300. B. $162,100. C. $4,700. D. $127,100.

9.

Use the following selected information for the Perriman Corporation to calculate the correct credit column total for a trial balance: Accounts receivable $ 27,200 Accounts payable 15,900 Building 359,600 Cash 55,600 Common shares 155,000 Dividends 4,800 Insurance expense 1,800 Retained earnings 133,800 Salary expense 52,500 Salary payable 3,600 Service revenue 193,200 A. $365,600 B. $304,700 C. $501,500 D. $506,300

10.

The journal entry to record the performance of services on account for $1,200 is: A. Accounts Payable 1,200 Service Revenue 1,200 B. C. D.

Accounts Receivable Service Revenue

1,200

Cash Service Revenue

1,200

Service Revenue Accounts Payable

1,200

1,200 1,200 1,200

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