Chapter 4: Transaction Analysis and The Recording Process

Question 1

What are the different approaches to recording transactions?

Answer 1

Cash and accrual accounts.

Each is based in unique assumptions.

The distinction between cash and accrual accounting lies in the interpretation of income and expenses. The definition of income from chapter 1 includes the terms revenues and gains. The terms revenue and income are interchangeable in this book.

Question 2

What is involved in the process of capturing and recording all relevant transactions and events?

Answer 2

This process begins with transaction analysis, whereby a transaction or event is analysed to determine its effect on the elements (asset, liability, owner’s equity, income and expense).

Once it has been determined which element(s) are affected, the information is recorded through the general journal (or special journal).

Processing of the information continues as the data is recorded in a ledger account, and a trial balance is prepared.

These concepts are introduced in this chapter. Recording continues through chapter 5, where we introduce trading entities that deal with inventory. Chapter 6 covers adjusting entries, and, in chapter 7, the four financial statements are prepared.

Question 3

What is cash-basis accounting?

Answer 3

Cash basis accounting follows a simple approach. All transactions for an entity within a particular accounting period are recorded on the basis of when the cash is actually received or paid.

Profit for the period is therefore determined as the difference between the cash received as income and the cash paid for expenses.

Advance payments or delays in payment mean the timing of cash receipts and payments has the potential to distort recorded performance when using this approach.

Question 4

Why is cash-basis accounting problematic?

Answer 4

This approach can be problematic because not all firms sell on a cash-only basis. Many businesses offer their customers credit terms, meaning they are able to take possession of products or receive services immediately, but pay for them at a later date.

Under cash-basis accounting, income is recorded only when the cash is received, which may be days or weeks later than when the goods or services are provided.

Reported income may become even more distorted if customers pay in advance (eg. to order products) as these receipts are considered income at the time the cash is received, even though the goods or services haven’t yet been provided.

Similarly, entities often make payments for expenses before or after the expense is due.

The cash basis often leads to misleading financial statements, as it fails to record revenue that has been earned but for which the cash has not been received. In addition, it only recognises expenses when they are actually paid.

Question 5

Who is likely to use cash-basis accounting?

Answer 5

Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP); hence, most large companies and government entities are required to use accrual-basis accounting instead.

Individuals and some small businesses, however, do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivable and payable amounts owing from customers or to suppliers.

Cash-basis accounting is not an acceptable accounting practice in South Africa.

Question 6

What is accrual-basis accounting?

Answer 6

Accrual-basis accounting records revenues and expenses when they have been earned or incurred, even if the related cash has not yet changed hands.

Using the accrual basis to determine profit better reflects the performance of an entity during a particular time period.

If the profit or loss for a period were to truly reflect all business-related transactions, it follows that all revenue and expense items should be taken into account regardless of whether the cash has been exchanged.

Question 7

When is there no difference between cash and accrual revenue?

Answer 7

Naturally, sometimes the earning of revenue and the receipt of cash occur simultaneously; hence, there is no difference between the cash and accrual revenue.

However, in reality, customers and clients are frequently offered credit terms enabling them to pay the amount owing some time later than the time of purchase.

Question 8

What is the difference between cash and accrual accounting?

Answer 8

If a sale takes place during an accounting period, and the cash is received from the customer after the end of the accounting period, cash accounting would recognise the revenue in the following period.

In contrast, accrual accounting would record the sale in this period, the period in which the sale occurs.

Similarly, a business may incur various ongoing expenses such as for telephone, electricity and gas, but only receive a quarterly account. If an account for the months of April, May and June was received and paid in July, cash accounting would record the expense in that month only. Realistically, the expense should be apportioned across the three months of April, May and June to determine the true profit or loss (after taking into account all other expenses) for each month.

Question 9

What can accountants do in situations when things aren’t payed for on time?

Answer 9

The way these sorts of situations are often accounted for involves recording a temporary asset or liability.

Eg. If a sale was made to a customer who did not pay immediately, the revenue under accrual accounting has been earned, but there is no cash in the cash register. Instead, an asset known as ‘debtors’ or ‘accounts receivable’ is created to recognise that the customer owes the outstanding amount to the business. When the customer pays the business in the following month, that asset is replaced with cash.

A similar situation may occur in relation to recording a liability due to the timing of cash payments. A business may have received an account for telephone or electricity, or an invoice for goods purchased on credit. In these circumstances a temporary liability known as ‘creditors’ or ‘accounts payable’ is created to recognise that an expense has been recorded but not yet paid.

As you can imagine, cash and accrual accounting will produce very different performance results for an accounting period.

Question 10

What is transaction analysis?

Answer 10

To be able to prepare general-purpose financial statements, entities must maintain an effective accounting system to record all daily transactions and events.

Transaction analysis is a tool that may be useful as an introductory step toward understanding the recording process.

Question 11

Concept of duality.

Answer 11

Many large businesses experience hundreds of transactions and events daily. The information relating to these must be managed in the accounting system in order for the general-purpose financial statements to be prepared at the end of the reporting period.

Each transaction or event affects at least one of the five elements, but at all times the accounting equation must remain balanced. An important part of understanding the effect of business transactions on the elements comprising the statement of financial position (balance sheet) and the statement of profit or loss is the concept of duality.

Question 12

What is the concept of duality?

Answer 12

This simply means that every business transaction will have a dual effect.

Eg 1. The purchase of a motor vehicle for $19,000 through a
bank loan will increase both an asset (the vehicle) and a liability (the loan).

Both sides of the accounting equation increase and it remains in balance.

Eg 2. An owner provides $50000 in cash funds to start the business.
Once again, a dual effect occurs, where the elements of asset and owner’s equity have both increased.

Eg 3. A business uses $350 cash to pay a supplier to whom money is owed for goods supplied. Cash (assets) and accounts payable (liabilities) decrease, meaning a reduction on both sides of the accounting equation.

Question 13

What else must be considered with the concept of duality?

Answer 13

Also be aware that the changes do not always take place on both sides of the equation. For example, consider a business that uses $1200 cash to purchase a computer.

One asset is increased (computer) while another is decreased (cash), leaving no overall change in the accounting equation. It is important that this concept is well understood, for accounting is based upon a system that maintains ‘double entries’, always ensuring the equation is balanced.

Question 14

Extended accounting equation.

Answer 14

A = L + OE + R - E

This extended equation illustrates that the result of revenue less expenses (either profit or loss) is considered to be an adjustment to owner’s equity. Entities frequently earn revenue, which contributes to profit.

Eg 1. A cash sale of $220 to a customer - increases revenue, which increase OE and therefore increase A = balance.

Eg 2. how is the accounting equation affected by incurring a wages expense of $990 where the employees have not yet been paid - increased expenses (decreased OE) and increased L = cancel each other out.

Question 15

How can the accounting equation be extended further?

Answer 15

A = L + OE + R - E + Additional Capital - Distributions

During the lifetime of an entity, additional contributions of capital may occur, increasing the total owner’s equity in the business.

Similarly, distributions may be made to the owner(s) of the business, known as drawings or, in the case of companies, dividends, which reduce the value of owner’s equity remaining in the business.

Eg 1. A business receives a $50000 cash contribution of additional capital during the year - this increases additional capital (increase OE), which increases A.

Eg 2. $5000 cash is withdrawn for the owner’s use - this increases (drawings/dividends) distributions (deceases OE), which decreases A.

Question 16

What is a situation which defies duality (involves more than two items)?

Answer 16

Assume a business earns revenue from sales totalling $10 000; however, $3400 was received in cash, while the remaining $6600 remains owing from customers:

A (cash $3400 + debtors $6600) = L + OE + R (sales $10000) -

Balance!!

Question 17

What happened when an asset is increased?

Answer 17

If an asset is increased, there must be a corresponding:
1. decrease in another asset, or
2. increase in a specific liability, or
3. increase in owner’s equity (via revenue or additional capital).

Any change in a liability or ownership claim is subject to similar analysis.

Pages 100-104 have good examples.

Question 18

What is part of the accounting function?

Answer 18

A part of the accounting function is to group and classify transactions into useful categories so that the results can be accumulated and summarised for reporting purposes.

To facilitate the accumulation of financial data, transactions are recorded in accounts.

Each transaction recorded will result in an increase or decrease in one or more of the assets, liabilities and owner’s equity accounts.

Question 19

What is an account?

Answer 19

An account is an individual accounting record of increases and decreases in a specific asset, liability or owner’s equity item.

Eg. Softbyte would have separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue, Salaries Expense and so on.

In its simplest form, an account consists of three parts.

Question 20

What are the three parts of an account?

Answer 20

(1) the title of the account,
(2) a left or debit side and
(3) a right or credit side.

Also, accounts will allow for recording the date of the transaction and an explanation of the transaction. A simplified format of account that resembles the letter T, referred to as a T account, is shown below:

                                       Title of account
             |    Left or debit side     |     Right or credit side    |
             —————————————————————
             |       Debit Balance       |         Credit Balance       |
             —————————————————————

Question 21

What are debits and credit?

Answer 21

Today, the term debit indicates left, and credit indicates right. They are commonly abbreviated as Dr for debit and Cr for credit.

Entering an amount on the left side of an account is called debiting the account; making an entry on the right side is crediting the account.

After transactions have been entered into each respective T account, the account balance can be determined. The account balance is the difference between the sum of its debits and the sum of its credits.

Question 22

Results seen in T accounts.

Answer 22

When the totals of the two sides are compared, an account will have a debit balance if the total of the debit amounts exceeds the credits.

An account will have a credit balance if the credit amounts exceed the debits.

Liability accounts will typically have credit balances, while asset accounts will typically have debit balances.

An account will have a zero balance if the sum of the debits equals the sum of the credits.

Question 23

What is a tabular summary?

Answer 23

The figures in columns of a tabular summary can be used for the respective T account. Eg. The cash column can be used for the cash T account (account form).

In the tabular summary every positive item represents a receipt of cash; every negative amount represents a payment of cash.

In the account form the increases in cash are recorded as debits, and the decreases in cash are recorded as credits.

Question 24

Debit and credit procedure.

Answer 24

The equality of debits and credits provides the basis for the double-entry system of recording transactions.

Under the double-entry system, the dual (two-sided) effect of each transaction is recorded in appropriate accounts. This universally used system provides a logical method for recording transactions. It also offers a means of proving the accuracy of the recorded amounts. If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits.

The double-entry system for determining the equality of the accounting equation is much more efficient than the plus/minus procedure used earlier.

Question 25

What is a great way of remembering where A, L, OE, R and E are allocated in T accounts?

Answer 25

⬆️ D C C C D
⚫️ A L O R E
⬇️ C D D D C

O = OE

Remember - OE easily changes from owner’s capital, owner’s drawings, revenue and expenses.

Question 26

What are the 4 basic steps in the recording process?

Answer 26

1. Identify the transaction from source documents.
2. Analyse each transaction for its effects on the accounts.
3. Enter the transaction information in a journal (book of original entry).
4. Transfer the journal information to the appropriate accounts in the ledger (book of accounts).

Although it is possible to enter transaction information directly into the accounts without using a journal or ledger, few businesses do so.

Question 27

How do the sequence of events in the recording process begin?

Answer 27

The sequence of events in the recording process begin with the transaction.

Evidence of the transaction is typically provided by a business document, such as a receipt, a cheque butt, an account or a cash register tape.

This evidence is analysed to determine the effects of the transaction on specific accounts. The transaction is then entered in the journal. Finally, the journal entry is transferred to the designated accounts in the ledger.

Question 28

What do source documents provide?

Answer 28

Source documents provide written evidence of a transaction and are used by the accounting department as support or evidence for entries recorded. It also serves as an important element in the control of the entity’s resources.

It is important to have a supporting source document for each transaction with an external party.

Question 29

What are journals?

Answer 29

Transactions are initially recorded in chronological order in journals before being transferred to the accounts.

Thus, the journal is referred to as the book of original entry. For each transaction the journal shows the debit and credit effects on specific accounts. (In a computerised system, ‘journals’ are now kept as files, and ‘accounts’ are recorded in computer databases.)

Businesses may use various kinds of journals, but every business has the most basic for of journal, a general journal.

Question 30

What is a general journal?

Answer 30

This is a basic form of journal which every business has. Typically, it has spaces for dates, account titles and explanations, references and two amount columns.

When ever we use the term ‘journal’ in this textbook without a modifying adjective, we mean the general journal.

The journal makes several significant contributions to the recording process?

Question 31

What are the several significant contributions to the recording process that the (general) journal makes?

Answer 31

1. It discloses in one place the complete effects of a transaction.
2. It provides a chronological record of transactions that cross references to both the source document and the ledger entry.
3. It helps to prevent or locate errors because the debit and credit amounts for each entry can be readily compared.

Question 32

What is journalising?

Answer 32

Entering transaction data in the journal is known as journalising.

Separate journal entries are made for each transaction. A complete entry consists of:

(1) the date of the transaction (column 1),
(2) the accounts (column 2) and amounts to be debited and credited (columns 3 and 4) and
(3) a brief explanation of the transaction (in column 2 - AKA narration).

Question 33

What is the standard form and content of journal entries?

Answer 33

1. The date of the transaction is entered in the Date column. The date recorded should include the year, month and day of the transaction.
2. The debit account titles (that is, the accounts to be debited - eg. Cash, accounts receivable etc. - order doesn’t matter) are entered first at the extreme left margin of column 2 and the amount of the debits are recorded in the Debit column.
3. The credit account titles (that is, the accounts to be credited - eg. Bank loan, capital etc. - order doesn’t matter) are indented (imagine pressing tab) and entered on the next line in column 2 and the amount of the credits are recorded in the Credit column.
4. A brief explanation or narration of the transaction is given on the line below the credit account title/s.
5. A space is left between journal entries. The blank space seperate so individual journal entries and makes the entire journal easier to read.

References to relevant ledgers accounts is not needed for now.

Question 34

What is a simple entry and what is a compound entry?

Answer 34

If an entry involves only two accounts, one debit and one credit, it is considered a simple entry. Some transactions, however, require more than two accounts in journalising.

When three or more accounts are required in one journal entry, the entry is referred to as a compound entry.

In a compound entry, the total debit and credit amounts must be equal. Also, the standard format requires that all debits be listed before the credits.

Question 35

What is the ledger?

Answer 35

The entire group of accounts maintained by a business is called the ledger. The ledger keeps in one place all the information about changes in specific account balances.

Businesses may use various kinds of ledgers, but every business has a general ledger.

Question 36

What does a general ledger contain?

Answer 36

A general ledger contains all the assets, liabilities and owner’s equity accounts.

A business can use a looseleaf binder or card file for the ledger in a manual system. If a manual system is used, each account is kept on a separate sheet or card.

Alternatively, in a computerised system each ledger account would be kept as a file or as part of a module within an accounting package. Transactions would be recorded either in batches or online.

Question 37

How should the ledger be arranged?

Answer 37

The ledger should be arranged in the order in which accounts are presented in the financial statements, beginning with the statement of financial position accounts.

First in order are the asset accounts, followed by liability accounts, owner’s capital, owner’s drawings, revenue and expenses. Each account is numbered for easier identification.

The ledger provides management with the balances in various accounts.

Amounts due from customers can be found by examining Accounts Receivable, and amounts owed to creditors can be found by examining Accounts Payable.

Question 38

What is posting?

Answer 38

The procedure of transferring journal entries to the ledger accounts is called posting. Posting involves the following steps.
1. In the ledger, enter in the appropriate columns of the account(s) debited the date, explanation, journal page and debit amount shown in the journal.
2. In the reference column of the journal, place a tick against the account number to which the debit amount was posted.
3. In the ledger, enter in the appropriate columns of the account(s) credited the date, explanation, journal page and credit amount shown in the journal.
4. In the reference column of the journal, place a tick against the account number to which the credit amount was posted.

Posting should be performed in chronological order. That is, all the debits and credits of one journal entry should be posted before proceeding to the next journal entry. Postings should be made on a timely basis to ensure that the ledger is up to date.

Question 39

What is a chart of accounts?

Answer 39

The number and type of accounts used differ for each entity. The number of accounts depends on the amount of detail desired by management.

Most entities have a chart of accounts that lists the accounts and the account numbers that identify their location in the ledger. The numbering system used to identify the accounts usually starts with the statement of financial position accounts and follows with the statement of profit or loss accounts.

Question 40

The recording process illustrated for service firms.

Answer 40

Pages 117 - 122.

Question 41

What is a trial balance?

Answer 41

A final part of the recording process to learn in this chapter relates to the trial balance. A trial balance is a list of accounts and their balances at a given time.

Customarily, a trial balance is prepared at the end of an accounting period. The accounts are listed in the order in which they appear in the ledger; debit balances are listed in the left column and credit balances in the right column.

The primary purpose of a trial balance is to prove (check) that the debits equal the credits after posting. In other words, the sum of the debit account balances in the trial balance should equal the sum of the credit balances.

If the debits and credits do not agree, the trial balance can be used to correct errors in journalising and posting. In addition, it is useful in the preparation of financial statements, as will be explained in forthcoming chapters.

Question 42

What are the steps for preparing a trial balance?

Answer 42

The steps for preparing a trial balance are as follows:
1. List the account titles and their balances (column 1)

2. Total the debit and credit columns (columns 2 and 3)
3. Prove the equality of the two columns (last row).

Question 43

What are the limitations of a trial balance?

Answer 43

A trial balance does not guarantee freedom from recording errors, however. It does not prove that all transactions have been recorded or that the ledger is correct.

Numerous errors may exist even though the trial balance columns agree. For example, a number of possible explanations may result in the equality of debits and credits, verifying that the trial balance is in balance; however, entries could have been incorrectly recorded.

Question 44

What are some examples of where the trial balance columns agree?

Answer 44

1. A transaction is completely omitted; that is, it is not journalised. Eg. equipment to the value of $4000 may have been purchased for cash. This should have been recorded as a debit to equipment and a credit to cash. If the transaction were omitted, equipment would be understated and the cash account would be overstated; however, the trial balance columns would still agree.
2. A correct journal entry is posted incorrectly. Eg. rent may have been paid; however, the transaction was posted as a credit to the rent expense account and a debit to the cash account. Debits still equal credits; however, the correct entry should have been a debit to the rent expense account and a credit to the cash account.
3. A journal was posted twice. Recording a transaction twice will ensure that the dual effect of each transaction is posted. Hence, debits will still equal credits.
4. Incorrect accounts are used in journalising or posting. Eg. rent expense may have been paid; however, the transaction was posted as a debit to the electricity account instead of a debit to the rent account.
5. Offsetting errors are made in recording the amount of the transaction. Eg. the amount may have been recorded as $201 instead of $210 in both accounts. This is commonly referred to as a transposition error.

In all the examples above, as long as equal debits and credits are posted, even to the wrong account or of the wrong amount, the total debits will equal the total credits.

Question 45

Use of dollar signs.

Answer 45

Note that dollar signs do not appear in the journals or ledgers.

Dollar signs are usually used only in the trial balance and the financial statements.

Generally, a dollar sign is shown only for the first item in the column and for the total of that column.

A single line is placed under the column of figures to be added or subtracted; the total amount is double underlined to indicate the final sum.