Accounting: The Language of Business (Part 11)

“In the long run managements stressing accounting appearance over economic substance usually achieve little of either.” —Warren Buffett

Analyzing Transactions (Part C)

by 

Charles Lamson

Illustration of Analyzing and Summarizing Transactions

How does a transaction take place in a business? First, a manager or other employee authorizes the transaction. The transaction then takes place. The businesses involved in the transaction usually prepare documents that give details of the transaction. These documents then become the basis for analyzing and recording the transaction. For example, Chris Clarke might authorized the purchase of supplies for NetSolutions by telling an employee to buy computer paper at the local office supply store. The employee purchases the supplies for cash and receives a sales slip from the office supply store listing the supplies bought. The employee then gives the sales slip to Chris Clark, who verifies it and records the transaction.

As we discussed in part 10, a transaction is first recorded in a journal. Thus, the journal is a history of transactions by date. Periodically, the journal entries are transferred to the accounts in the ledger. The ledger is a history of transactions by account. The process of transferring the debits and credits from the journal entries to the accounts is called posting. The flow of a transaction from its authorization to its posting in the account is shown in Exhibit 2.

EXHIBIT 2

In practice, businesses use a variety of formats for recording journal entries. A business may use one all-purpose journal, sometimes called a two-column journal, or it may use several journals. In the latter case, each journal is used to record different types of transactions, such as cash receipts or cash payments. The journals may be part of either a manual accounting system or a computerized accounting system.

The double-entry accounting system is a very powerful tool in analyzing the effects of transactions. Using this system to analyze transactions is summarized as follows:

1. Determine whether an asset, a liability, owner's equity, revenue, or expense account is affected by the transaction.

2. For each account affected by the transaction, determine whether the account increases or decreases.

3. Determine whether each increase or decrease should be recorded as a debit or a credit.

To illustrate recording a transaction in an all-purpose journal and posting in a manual accounting system, we will use the December transactions of NetSolutions. The first transaction in December occurred on December 1.

December 1. NetSolutions paid a premium of $2,400 for a comprehensive insurance policy covering liability, theft, and fire. The policy covers a two-year period.

Analysis When you purchased insurance for your automobile, you may have been required to pay the insurance premium in advance. In this case, your transaction was similar to NetSolutions. Advance payments of expenses such as insurance are prepaid expenses, which are assets. For net Solutions, the asset acquired for the cash payment is insurance protection for 24 months. The asset Prepaid Insurance increases and is debited for $2,400. The asset cash decreases and is credited for $2,400. the recording and posting of this transaction is shown in Exhibit 3.

EXHIBIT 3 Diagram of the Recording and Posting of a Debit and a Credit

Note where the date of the transaction is recorded in the journal. Also note that the entry is explained as the payment of an insurance premium. Such explanations should be brief. For unusual and complex transactions, such as a long-term rental arrangement, the journal entry explanation may include a reference to the rental agreement or other business document. 

You will note that the T account form is not used in this illustration. Although the T account clearly separates debit and credit entries, it is inefficient for summarizing a large quantity of transactions. In practice, the T account is usually replaced with the standard form shown in Exhibit 3.

The debits and credits for each journal entry are posted to the accounts in the order in which they occur in the journal. In posting the standard account, (1) the date is entered, and (2) the amount of the entry is entered. For future reference, (3) the journal page number is inserted in the posting reference column of the account, and (4) the account number is inserted in the posting reference column of the journal.

The remaining December transactions for NetSolutions are analyzed in the next post.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 55-57*

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