Chapter 3

Recording Transactions

Learning Objectives
After studying this chapter, you should be able to:

Use double-entry accounting.

Analyze and journalize transactions.
Post journal entries to the ledgers.
Prepare and use a trial balance.
Close revenue and expense accounts and update retained
income.
Correct erroneous journal entries and describe how errors affect
accounts.
Use T-accounts to analyze accounting relationships.
Explain how computers have transformed processing of
accounting data.

The Double-Entry
Accounting System
Some businesses enter into thousands of
transactions daily or even hourly.
Accountants must carefully keep track of and
record these transactions in a systematic manner.

Double entry accounting system is the method usually

followed for recording transactions, whereby every
transaction affects at least two accounts

The Double-Entry
Accounting System
Each transaction must still be analyzed to determine
which accounts are involved,
whether the accounts increase or decrease, and

how much the balance will change.

The balance sheet equation can be used for this

analysis, but with so many transactions, this is not
realistic.
In practice, accountants use ledgers.

Ledger Accounts
Ledger contains the record for a group of
related accounts kept current in a
systematic manner
Think of a ledger as a book with
one page for each account.
The ledger is a companys books.

General ledger - the collection of

accounts that accumulates the
amounts reported in the major
financial statements

Ledger

Ledger Accounts
A simplified version of a ledger account is called the
T-account.
They allow us to capture the essence of the
accounting process without having to worry about too
many details.
The account is divided into two sides for recording
increases and decreases in the accounts.

Account Title
Left Side

Right Side

Ledger Accounts
In practice, accounts are created as per the
need
The process of creating a new account is
called Opening the Account
Each T-Account summarizes the changes in
the particular accounts
T-Accounts show only the Amounts and NOT
the transaction description

Ledger Accounts
Balance - difference between total left-side amounts
and total right-side amounts at any particular time
Assets have left-side balances.
Increased by entries to the left side
Decreased by entries to the right side
Liabilities and Owners Equity have right-side
balances.
Decreased by entries to the left side
Increased by entries to the right side

Ledger Accounts
T-accounts and the balance sheet
equation:

Assets = Liabilities + Owners Equity

Assets
Increases

Decreases

Liabilities
Decreases

Increases

Owners Equity
Decreases

Increases

Ledger Accounts
Each transaction generates a right side
entry in one T- account and a left side
entry in another T- account, of the same
amount if there are only two accounts
affected.
Compound entries effect more than 2 Taccounts with different amounts.

Debits and Credits

Debit (dr.) Denotes an entry on the
left side of an account
Credit (cr.) Denotes an entry on the
right side of an account

Remember:
Debit is always the left side!
Credit is always the right side!

The Recording Process

The sequence of steps in recording
transactions:
Transactions

Source
Documentation

Journal

Financial
Statements

Trial
Balance

Ledger

The Recording Process

Step 1.
The process starts with source documents, which are
the supporting original records of any transaction.
Examples are sales slips or invoices, check stubs,
purchase orders, receiving reports, and cash
receipt slips.

The Recording Process

Step- 2
In the second step, an analysis of the transaction is
placed in the book of original entry, which is a
chronological record of how the transactions affect
the balances of applicable accounts.
The most common example is the
General Journal - a diary of all events
(transactions) in an entitys life.

The Recording Process

Step-3
In the third step, transactions are entered into the
ledger.
Remember that a transaction is not entered in just
one place; it must be entered in each account that
it affects.
Depending on the nature of the organization,
analysis of the transactions could occur
continuously or periodically.

The Recording Process

Step-4
The fourth step includes the preparation of the Trial
Balance, which is a simple listing of all accounts in
the general ledger with their balances.
Aids in verifying accuracy and
in preparing the financial statements
Prepared periodically as necessary

The Recording Process

Step-5
In the final step, the Financial Statements are
prepared.
Financial statements are prepared each quarter of
the year for publicly traded companies.
Other companies prepare
December 2002
financial statements at
various other intervals to
meet the needs of their users.

Journalizing Transactions
Journalizing - the process of entering
transactions into the journal
Journal entry - an analysis of the effects of a
transaction on the accounts, usually
accompanied by an explanation of the
transaction
This analysis identifies the accounts to be
debited and credited.

Journalizing Transactions
The conventional form for journal entries
includes the following:
The date and identification number of the entry
The accounts affected and an explanation of the
transaction
The posting reference, which is the number
assigned to each account affected by the
transaction
The amounts that the accounts are to be debited
and credited

Journalizing Transactions
A journal entry for the following transaction will look
like this:
Purchased merchandise inventory for cash
Rs.1,50,000 on Jan 1, 2002
Journal entry
2002
Jan 2

dr.
Inventory 1,50,000
Cash

cr.

1,50,000

Journalizing Transactions
The conventional form for recording in
the general journal:
Entry
Date No.
2001
12/31

12/31

2002
1/2

Post.
Ref Debit

Credit

Cash
Paid-in capital
(Capital Stock issued)

100
300

400,000
400,000

Cash
Note payable
(Borrowed at 9% interest on a 1 yr note)

100
202

100,000

Merchandise inventory
Cash
(Acquired inventory for cash)

130
100

150,000

Accounts and Explanations

100,000

150,000

Chart of Accounts
Chart of accounts - a numbered or coded list
of all account titles used to record
transactions

Account
Number
100
120
130
140
170
170A

Account
Title

Cash
Accounts receivable
Merchandise inventory
Prepaid rent
Store equipment
Accumulated
depreciation

Account
Number

Account
Title

202
203
300
400
500
600
601
602

Notes payable
Accounts payable
Paid-in capital
Retained income
Sales revenue
Cost of goods sold
Rent expense
Depreciation expense

Posting Transactions
to the Ledger
Posting is the transferring of amounts from the
journal to the appropriate accounts in the ledger
Dates, explanations, and journal references are
provided in detail on paper formatted with special
columns.
Strictly a mechanical process and hence generally
done electronically

Posting Transactions
to the Ledger
Cross-referencing - the process of numbering or
otherwise specifically identifying each journal entry
and each posting

Transactions are often posted to several different

accounts, but cross-referencing allows users to
find all components of a transaction in the ledger
no matter where they start.
Cross-referencing also allows auditors to find and
correct errors.

Analyzing, Journalizing, and

Posting Transactions
Types of journal entries:
Simple entry - an entry for a transaction that
affects only two accounts
Compound entry - an entry for a transaction that
affects more than two accounts

Remember: whether the entry is simple or

compound, the debits (left side) and credits (right
side) must always equal.

Analyzing, Journalizing, and Posting

Transactions
Jan 3

The company buys bicycles for Rs.10,000 from a

manufacturer. Manufacturer requires Rs.4,000 by Jan 10 and
balance in 30 days

Jan 4

Co. buys store equipment for a total of Rs.15,000. A cash

down payment of Rs.4,000 is made. Remaining must be paid in
60 days

Jan 5

Co. sells a store equipment to another business. Its selling

price is Rs.1,000 which is exactly equal to its cost. The buyer
agrees to pay within 30 days

Jan 6

Co. returns inventory worth Rs.800 which had been acquired

on credit on Jan 3 to the manufacturer.

Jan 10

Co pays to the manufacturer Rs.4,000 for Jan 3 transaction

Jan 12

Co. collects Rs.700 of Rs.1,000 for the store equipment it had

sold on Jan 5

Jan 12

The owner remodels his home Rs.35,000 paying by cheque

from his personal account

Revenue and Expense Transactions

Retained Income is merely accumulated
revenues less expenses, but we cannot just
increase or decrease the Retained Income
account directly.
This would make preparing the income statement
very difficult

By accumulating revenues and expenses

separately, a more meaningful income
statement can be easily prepared.

Revenue and Expense Transactions

Revenue and expense accounts are a part of Retained Income.
They are LITTLE STOCKHOLDERS ACCOUNT

Retained Income
Decrease

Expense

Increase

Revenue

Debit

Credit

Increase

Increase

Revenue and Expense Transactions

Summary of revenue and expense
transactions:
A credit to a revenue increases the revenue
and increases Retained Income.
A debit to a revenue decreases the revenue
and decreases Retained Income.
A credit to an expense decreases the expense
and increases Retained Income.
A debit to an expense increases the expense
and decreases Retained Income.

Revenue and Expense Transactions

Keeping revenues and expenses in separate
accounts makes the preparation of the
income statement easier.
The income statement provides a detailed
explanation of how operations caused the balance
of Retained Income shown on the balance sheet
to change from the beginning of the
year to the end of the year.

Prepaid Expense and Depreciation

Transactions
Prepaid expenses relate to assets having
useful lives that will expire sometime in the
future.
The expiration, or using up, of those assets is an expense.

With depreciation, a new account,

Accumulated Depreciation, is introduced.
the cumulative sum of all depreciation recognized
since the date of acquisition of a particular asset

Prepaid Expense and Depreciation

Transactions
Contra account :
An accounts such as Accumulated Depreciation is
called a contra account, which is a separate but
related account that offsets or is a deduction from a
companion account.
Book value - the balance of an account, net of any
contra accounts (net book value, carrying amount, or
carrying value)

= Acquisition Cost - Accumulated Depreciation.

Accumulated Depreciation

Why use accumulated depreciation?

Why not just reduce the asset account
as it expires?

Transactions in the
Journal and Ledger

Some details to remember:

Do not use Rupee signs in either the
journal or the ledger.
Do not use negative numbers. The effect
on the account is conveyed by the side
(debit or credit) on which the number
appears.

Trial Balance
Once all transactions have been posted to the
ledger, a trial balance is prepared.
Trial balance - a list of all of the accounts with their
balances

The purposes of the trial balance:

To help check on accuracy of posting by proving whether
the total debits equal the total credits
To establish a convenient summary of balances in all
accounts for the preparation of formal financial statements

Preparing the Trial Balance

The trial balance is usually prepared with the balance sheet accounts
first, followed by the income statement accounts.

Order is : Current Assets

Fixed Assets
Current Liabilities
Long term Liabilities
Paid in Capital
Retained Incomes
Sales Revenue
COGS
Expenses
TOTAL

Preparing the Trial Balance

An example of a short trial balance:
Account
Number
100
130
202
300

Account Title
Cash
Merchandise inventory
Note payable
Paid-in capital

Debit

Credit

$350,000
150,000
$100,000
400,000

500,000
==================

5,00,000
=

==================

Deriving Financial Statements from

the Trial Balance
The trial balance is the starting point for the
preparation of the balance sheet and the income
statement.

The income statement accounts are summarized

later in a single account called Net Income, which
becomes part of Retained Income in the balance
sheet.

ABC Company,
Trial Balance January 30,2008
Debits
Cash

336700

A/R

160300

Inventory

59200

Prepaid Rent

4000

Machinery

14000

Accumulated Depreciation, Machinery

Credits

100

Loan

100000

A/P

16200

Paid in Capital

400000

Retained Income

Sales Revenue
COGS

160000
100000

Salary Expense

2000

Depreciation expense

100

TOTAL

676300

676300

Disadvantage of the Trial Balance

Note that a trial balance may balance even when
errors were made in recording or posting.
A transaction may be recorded in different
amounts
A transaction may be recorded in a wrong
account.
In both situations, the total debits will still equal total
credits on the trial balance.
Dr. = Cr.

Closing the Accounts

Once the financial statements are prepared,
the ledger accounts must be prepared to
record the next periods transactions. This
process is called closing the books.
The balances in all temporary stockholders
equity accounts are transferred to a Retained
Income Account via a temporary Income
Summary account.
The revenue and expense accounts are reset to
zero and the current net income is transferred to
Retained Income.

The Closing Process

Step 1:
The revenue accounts are closed to Income Summary

Step 2:
The expense accounts are closed to Income Summary

Step 3:
The amount of Net Income (revenues - expenses) is
then transferred from Income Summary to Retained
Income.

Capital Vs Revenue
The items of expenses and income, are termed as
Revenue by accountants- they are short lived and
closed by transferring to Income Summary Account
The credit and debit balances in Trial Balance which
remain unclosed (not transferred to Income Summary
Account) are called Capital- They survive and move
to the next year as opening balances
- All Asset accounts, Liability accounts, Paid in Capital and
Retained Earnings account are called Capital

Effects of Errors
When a journal entry contains an error, it can be
erased or crossed out only if the error is detected
before the entry is posted to the ledgers.

If the error is detected after posting, a correcting

entry must be made.
The correcting entry counteracts the incorrect
entry and assures that the correct account is
debited or credited for the proper amount.

Effects of Errors
A correcting entry is recorded in the
General Journal and posted to the
ledger exactly as regular entries are.
Focus is on the FINAL BALANCES of
accounts and not on the flow of entries,
because ultimately it is the FINAL
BALANCES that are used for preparing
the Financial Statements

Correcting Entry
Equipment account erroneously debited
for a repair expense paid on 31st Jan,
2009. The error is detected on 1st Feb..
What is the erroneous entry?
What should have been the correct entry?
What should be the correcting entry to be
passed on 1st Feb?

Types of Error
Errors of CommissionWhen a wrong account is journalized (debited or
credited) or a wrong amount is entered.
Errors of PrinciplesAn error due to non-compliance of rules of
accounting
Error of OmissionThe complete omission of a transaction due to
neglect of recklessness

Effect of Errors
Some errors may be Temporary while some errors
persist till corrected.
1. Temporary Errors
- Some errors, which remain undetected by
accountants, can effect a variety of items including
revenue and expenses for a given period.
- However they get automatically corrected in the next
period- they have counterbalance effect in two
accounting periods which nullifies their effect

Effect of Errors
E.g.- Rent paid in advance, Rs.100 on 1st
December 2007 for the month of January
2008, wrongly recorded as Rent Expense

Incorrect Entry
On 1st Dec 2007

Correct Entry
On 1st Dec 2007

Rent Exp100 Prepaid Rent..

Cash
100
Cash..

Correct Entry
On 31st Jan 2008
Rent Exp
Prepaid Rent.

Effect in 1st year (2007) Effect in 2nd year(2008)

-Rent Expense will be
overstated by 100

-Rent expense understated

by 100

-Pre tax Income will be

understated 100

-Pre tax Income overstated

by 100

-Assets understated by 100 -No effect

2. Errors that are not

counterbalanced
Errors that are not counterbalanced will
keep the balance sheet incorrect
until correcting entries are made.
e.g.: Overlooking a depreciation expense by Rs.500 in
year 1
Effect:
Year 1: Overstated Pretax income, Assets and Retained
Income
Subsequent Years: Overstated Asset and RI

Incomplete Records
Accountants must sometimes fill in the blanks
when accounting records are lost, stolen, or
destroyed.

T-accounts can help to recreate and calculate

unknown amounts.
The accountant must understand the account
and the amounts that flow through it in order to
determine unknown amounts.
This process can become extremely complicated
when many accounts are used.

Incomplete Records
You need to help a store owner in calculating
the sales for the year 2008 as he has lost the
records. Following information has been
provided by him:

List of customers who owe moneyOn December 31st, 2007= Rs.14000

On December 31st, 2008= Rs.28,000
Cash receipts from customers during 2008
=Rs.4,00,000 (All sales being on credit)

Data Processing and Computers

Data processing - the procedures used to record,
analyze, store, and report on chosen activities
An accounting system is one type of data
processing system.
Accounting systems are now likely to be
computerized, but regardless of format,
information still must be entered.

Data Processing and Computers

Advantages to computerized systems:

Managers can get daily financial reports.
Employees can enter transactions into a terminal, such as a
cash register, and the computer will perform many tasks
(update inventory, perform credit checks, and prepare
monthly statements for mailing to customers).
The computer can automatically record each transaction as
soon as it happens thereby reducing much of the paperwork
and data processing costs.