ANALYZING TRANSACTIONS: The Accounting Equation CHAPTER ONE ANALYZING TRANSACTIONS: The Accounting Equation

BUSINESS ENTITY An individual, association, or organization That engages in economic activities And controls specific economic resources Business entity’s finances kept separate from those of owner (Business Entity Concept)

ITEMS OWNED BY A BUSINESS THAT WILL PROVIDE FUTURE BENEFITS ASSETS ITEMS OWNED BY A BUSINESS THAT WILL PROVIDE FUTURE BENEFITS MUST BE “OWNED” NOT RENTED

ASSETS EXAMPLES: CASH MACHINERY MERCHANDISE BUILDINGS FURNITURE LAND FIXTURES MACHINERY BUILDINGS LAND ACCOUNTS RECEIVABLE Can chickens be an asset?

ACCOUNTS RECEIVABLE The amount of money owed to the business by its customers As a result of making sales “on account” or “on credit” Simply, customers who have promised to pay sometime in the future

What the business owes others LIABILITIES What the business owes others In other words. . . DEBTS OR OBLIGATIONS OF THE BUSINESS THAT must be paid later.

LIABILITIES EXAMPLES: ACCOUNTS PAYABLE (short term credit) NOTES PAYABLE (longer term credit) We don’t want Guido the Enforcer coming to collect. We will always pay our bills on time!

ACCOUNTS PAYABLE “I need those supplies now but I want to pay for them later! I will buy them “on account” for now.” Be careful!! Don’t confuse Accounts Receivable and Accounts Payable. Ask yourself, are we waiting to receive? Or waiting to pay?

NOTES PAYABLE Formal written promises to pay suppliers or lenders Specific sums of money at definite future times

OWNER’S EQUITY ALSO CALLED: OR Once the liabilities are paid, the remaining assets belong to the owner (Owner’s Equity). ALSO CALLED: NET WORTH CAPITAL OR

Can also be expressed as: Assets = Liabilities + Owner’s Equity EXAMPLE: If a business has total Assets of $100,000 and total Liabilities of $60,000, what is the Owner’s Equity? FORMULA: = ASSETS LIABILITIES OWNER’S EQUITY $40,000 $100,000 $60,000 = Can also be expressed as: Assets = Liabilities + Owner’s Equity

BUSINESS ENTITY CONCEPT Owner may have business assets and liabilities and personal assets and liabilities. Personal assets and liabilities are not included in the entity’s accounting records A sauna owned by the owner is not a business asset.

ACCOUNTING EQUATION Assets = Liabilities + Owner’s Equity Left side:

ACCOUNTING EQUATION + Assets = Liabilities Owner’s Equity Right side shows where the money came from to buy the assets

BUSINESS TRANSACTION An economic event that has a direct impact on the business Usually requires an exchange with an outside entity Must be able to measure this exchange in dollars All transactions affect the accounting equation through specific accounts

An ACCOUNT is. . . A separate record used to summarize changes in each asset, liability, and owner’s equity of a business

ANALYZING BUSINESS TRANSACTIONS QUESTION #1 What happened? Make certain you understand the event that has taken place.

Which accounts are affected? QUESTION #2 Which accounts are affected? Identify the accounts that are affected. Classify these accounts as assets, liabilities, or owner’s equity.

How is the accounting equation affected? QUESTION #3 How is the accounting equation affected? Determine which accounts have increased or decreased. Make certain that the accounting equation remains in balance after the transaction has been entered.

Let’s analyze the effect of transactions on the accounting equation for Mary Adams Consulting

EXAMPLE: Mary Adams, the owner, invested $25,000 of her own money in the business.

QUESTION #1 What happened? Mary took $25,000 from her personal bank account and deposited it in a new account in the business’ name

Identify accounts that are affected QUESTION #2a Identify accounts that are affected CASH M. A. CAPITAL

Classify these accounts QUESTION #2b Classify these accounts CASH M. A. CAPITAL ASSET OWNER’S EQUITY

Determine whether the accounts have increased or decreased QUESTION #3a Determine whether the accounts have increased or decreased CASH M. A. CAPITAL

Does accounting equation balance? plus Owner’s Equity of $25,000 QUESTION #3b Does accounting equation balance? + ASSETS = LIABILITIES OWNER’S EQUITY CASH = M. A.,CAPITAL +$25,000 = +$25,000 It Balances! Assets of $25,000 = Liab. of $0 plus Owner’s Equity of $25,000

I guess M&M’s wouldn’t be considered an office supply. . .doggonit! EXAMPLE: PURCHASED OFFICE SUPPLIES FOR $800 CASH I guess M&M’s wouldn’t be considered an office supply. . .doggonit!

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts OFFICE SUPPLIES CASH ASSET ASSET

QUESTION #3a Increase or Decrease? OFFICE SUPPLIES CASH ASSET ASSET

Let’s look at the accounting equation QUESTION #3b Let’s look at the accounting equation + ASSETS LIAB. = O. E. + CASH OFF. SUPPLIES = + +$800 -$800 = Right hand side of equation is not affected

QUESTION #3b + + + Does transaction balance? +$800 = -$800 = ASSETS LIAB. = O. E. + CASH OFF. SUPPLIES = + +$800 -$800 = Yes! Total Assets stayed the same. One Asset increased, the other decreased. No change in Liabilities or Owner’s Equity

Is ourAccounting Equation in Balance after both transactions? + ASSETS = LIAB. O. E. + = CASH OFF. SUPPLIES M. A.,CAPITAL a. $25,000 $25,000 b. -800 +800 $24,200 $800 $25,000 bal $0 $25,000 $25,000 + = Yes! Total Assets =Liabilities + Owner’s Equity

Transaction #3 (She paid no cash today.) Mary is buying this $3,000 copy machine “on account.” She will be making payments on it over the next few years. (She paid no cash today.)

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts EQUIP. ACCOUNTS PAYABLE ASSET LIABILITY

QUESTION #3a Increase or Decrease? EQUIP. ACCOUNTS PAYABLE ASSET LIABILITY

Let’s look at the accounting equation: QUESTION #3b Let’s look at the accounting equation: + ASSETS = LIABILITIES OWNER’S EQUITY EQUIP. ACCOUNTS PAYABLE = This transaction had no effect on Owner’s Equity + $3,000 = + $3,000

Does transaction balance? QUESTION #3b Does transaction balance? + ASSETS = LIABILITIES OWNER’S EQUITY EQUIP. ACCOUNTS PAYABLE = + $3,000 = + $3,000 It Balances! Assets increased by $3,000 = Liab. Increased by $3,000

Is the Accounting Equation in Balance after all transactions? + = ASSETS LIAB. O. E. + + = CASH OFF. SUPPLIES Equip. Accts. payable M. A.,CAPITAL a. 25,000 25,000 = b. -800 +800 = +3,000 +3,000 c. = 25,000 bal 24,200 +800 +3,000 + = $3,000 $25,000 $28,000

Mary made a $400 payment on the copy machine she bought earlier. EXAMPLE Mary made a $400 payment on the copy machine she bought earlier. 400.00 Four Hundred -----00

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts CASH ACCOUNTS PAYABLE ASSET LIABILITY

QUESTION #3a Increase or Decrease? CASH ACCOUNTS PAYABLE ASSET LIABILITY

Let’s look at the accounting equation: QUESTION #3b Let’s look at the accounting equation: + ASSETS = LIABILITIES OWNER’S EQUITY CASH ACCOUNTS PAYABLE = This transaction had no effect on Owner’s Equity - $400 = - $400

Does transaction balance? QUESTION #3b Does transaction balance? + ASSETS = LIABILITIES OWNER’S EQUITY CASH ACCOUNTS PAYABLE = - $400 = - $400 It Balances! Assets decreased by $400 = Liab. decreased by $400

TOTAL Owner’s Equity EXPENSES REVENUES DRAWING INVESTMENTS These cause Owner’s Equity to DECREASE: These cause Owner’s Equity to INCREASE: EXPENSES REVENUES DRAWING INVESTMENTS

Record ALL EARNED revenue!! Amount a business charges customers for products sold or services performed Record ALL EARNED revenue!! EXAMPLES: Delivery Fees Consulting Fees Rent Revenue (if business rents space to others) Interest Revenue (for interest earned on bank deposits) Sales (for sales of merchandise)

EXPENSES EXAMPLES: Rent Salaries Supplies Consumed Taxes Represent the decrease in assets as a result of efforts made to produce revenues Separate accounts are maintained for each type of expense EXAMPLES: Rent Salaries Supplies Consumed Taxes Would I record this utility bill that I got in the mail as an expense? I don’t intend to pay it until next month. . .

$1,000 NET INCOME = = $6,000 $5,000 REVENUE EXPENSES NET INCOME REVENUE Greater than EXPENSES = NET INCOME EXAMPLE: Lance Armpit performed $6,000 of Catering services (Revenue) this year and incurred expenses of $1,500 for Rent, $500 for Supplies, and $3,000 in Salaries. REVENUE EXPENSES = NET INCOME $1,000 $6,000 $5,000 = $1,500 + $500 + $3,000

NET LOSS ($1,500) = = $8,000 $9,500 REVENUE EXPENSES NET LOSS EXPENSES Greater than REVENUE = NET LOSS EXAMPLE: John Elwho performed $8,000 of Delivery services (Revenue) this year and incurred Expenses of $3,500 for Rent, $500 for Supplies, $3,000 in Salaries and $2,500 for Gasoline. = REVENUE EXPENSES NET LOSS ($1,500) $8,000 $9,500 = $3,500 + $500 + $3,000 + $2,500

ACCOUNTING PERIOD CONCEPT Says that income can be determined for any period of time (month, quarter, year, etc.) Any accounting period of twelve months is called a FISCAL YEAR

WITHDRAWALS The owner taking (withdrawing) cash or other assets from the business for personal use Reduces Owner’s Equity and Assets Also referred to as Drawing

REVENUE EXAMPLE: Mary did some consulting work for a local company. Her consulting revenue was $4,500 and she was paid in cash immediately.

The two accounts effected are: QUESTIONS #1 & #2 The two accounts effected are: CASH CONSULTING FEES (ASSET) (OWNER’S EQUITY- REVENUE)

Does transaction balance? Owner’s Equity increased by $4,500 QUESTION #3b Does transaction balance? + ASSETS = LIAB. OWNER’S EQUITY CASH CONSULT. FEES = +$4,500 = +$4,500 It Balances! Assets increased by $4,500 = Owner’s Equity increased by $4,500

Left side of the Accounting Equation : ASSETS: CASH + SUPPLIES EQUIPMENT + $23,800 $800 $3,000 BAL. + $4,500 $28,300 $800 $3,000 BAL. $32,100

Right Side of the Accounting Equation LIABILITIES OWNER’S EQUITY + ACCOUNTS. PAYABLE. + M. A., CAPITAL + CONSULTING. FEES $25,000 $2,600 BAL. + $4,500 BAL. $2,600 $25,000 $4,500 $32,100

Mary paid her assistant $750 in wages EXPENSE EXAMPLE Mary paid her assistant $750 in wages

QUESTIONS #1 & #2 WHICH ACCOUNTS WERE EFFECTED? CASH WAGES EXPENSE **Even though the Expense account went up, It caused TOTAL Owner’s Equity to go down! CASH WAGES EXPENSE ASSET OWNERS EQUITY- EXPENSE

QUESTION #3b + Does transaction balance? CASH WAGES EXPENSE = - $750 = As expenses go up, Owner’s Equity goes down!!! Does transaction balance? + ASSETS = LIAB. OWNER’S EQUITY CASH WAGES EXPENSE = - $750 = +$750 It Balances! Assets decreased by $750 = Owner’s Equity decreased by $750

Left side of the a Accounting Equation: ASSETS: CASH + SUPPLIES + EQUIPMENT $28,300 $800 $3,000 BAL. - $750 BAL. $27,550 $800 $3,000 $31,350

Right Side of the Accounting Equation: LIAB. OWNER’S EQUITY ACCTS. PAY. M. A., CAPITAL + + REV. - EXPENSES $25,000 $4,500 $2,600 BAL. + $750 BAL. $2,600 $25,000 $4,500 $750 $2,600 + $25,000 + $4,500 $750 = $31,350

REVENUE ON ACCOUNT EXAMPLE: MARY PERFORMED $6,000 OF SERVICES “ON ACCOUNT”

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts Mary has performed services for this client. Client will be paying Mary at a later date. IT IS REVENUE EVEN THOUGH NO CASH CHANGED HANDS TODAY!

Which accounts were affected? QUESTIONS #1 & #2 Which accounts were affected? CONSULTING FEES ACCOUNTS RECEIVABLE O.E. -REVENUE ASSET

Does transaction balance? Owner’s Equity increased by $6,000 QUESTION #3b Does transaction balance? + ASSETS = LIAB. OWNER’S EQUITY ACCTS. RECEIVABLE CONSULT. FEES = +$6,000 = +$6,000 It Balances! Assets increased by $6,000 = Owner’s Equity increased by $6,000

CUSTOMER PAYMENT EXAMPLE Received $2,500 in cash for services performed in previous transaction

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts When Mary provided the consulting services, this client agreed to pay at a later date. TODAY THEY GAVE MARY CASH OF $2,500 AS A PARTIAL PAYMENT.

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts CASH ACCOUNTS RECEIVABLE ASSET ASSET

QUESTION #3b + Does transaction balance? = +$2,500 -$2,500 = ASSETS LIAB. = O. E. CASH ACCTS. REC. = +$2,500 -$2,500 = Yes! Total Assets stayed the same. One Asset increased, the other decreased. No change in Liabilities or Owner’s Equity

DRAWING EXAMPLE: Mary withdrew $1,500 so she could take a personal vacation to Tahiti

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts Mary is withdrawing some of her equity in the business by taking home an asset (Cash). This will also reduce her Owner’s Equity.

QUESTIONS #1 & #2 What accounts are affected? M. A., DRAWING CASH BE CAREFUL! Just like Expenses, the Drawing account will increase in this situation, but it will cause an overall DECREASE IN OWNER’S EQUITY. What accounts are affected? M. A., DRAWING CASH ASSET O.E.- DRAWING

Does the transaction balance? Owner’s Eq. decreased by $1,500 QUESTION #3b Does the transaction balance? + ASSETS = LIAB. OWNER’S EQUITY CASH - M.A., DRAWING = -$1,500 = +$1,500 It Balances! Assets decreased by $1,500 = Owner’s Eq. decreased by $1,500

FINANCIAL STATEMENTS THREE COMMONLY PREPARED FINANCIAL STATEMENTS: 1. INCOME STATEMENT 2. STATEMENT OF OWNER’S EQUITY 3. BALANCE SHEET

INCOME STATEMENT Reports the profitability of a business For a specific period of time (month, quarter or year) Revenues - Expenses = Net Income/Loss

Financial Statement headings: 1st line: Name of Company Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- Financial Statement headings: 1st line: Name of Company 2nd line: Title of Statement 3rd line: Time Period or specific date

This column is used for listing items to be totaled Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- This column is used for listing items to be totaled

This column is used for Totals Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- This column is used for Totals

a column should include Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- Revenues: Consulting Fees $2,150 First item at the top of a column should include “$”

Underline before totaling Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- Revenues: Consulting Fees $2,150 Expenses: Wages Expense $ 650 Rent Expense 200 Telephone Expense 50 Total Expenses 900 Underline before totaling

Revenues are greater than Expenses, Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- Revenues: Consulting Fees $2,150 Expenses: Wages Expense $ 650 Rent Expense 200 Telephone Expense 50 Total Expenses 900 Net Income $1,250 Revenues are greater than Expenses, therefore total is called NET INCOME

Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- Revenues: Consulting Fees $2,150 Expenses: Wages Expense $ 650 Rent Expense 200 Telephone Expense 50 Total Expenses 900 Net Income $1,250 Double underline

STATEMENT OF OWNER’S EQUITY Reports the activities that affected Owner’s Equity For a specific period of time Uses Net Income from the Income Statement

Instead of showing Revenue increasing & Jessica Jane’s Campus Delivery Statement of Owner’s Equity For Month Ended June 30, 20-- Jessica Jane, capital, June 1, 20-- $2,000 Net Income for June $1,250 Instead of showing Revenue increasing & Expenses decreasing the Owner’s Equity, this statement uses the net effect (Net Income/Loss) from the Income Statement.

$1,250 Net Income - $150 Withdrawal = $1,100 increase in Capital Jessica Jane’s Campus Delivery Statement of Owner’s Equity For Month Ended June 30, 20-- Jessica Jane, capital, June 1, 20-- $2,000 Net Income for June $1,250 Less drawing for June 150 Increase in Capital 1,100 $1,250 Net Income - $150 Withdrawal = $1,100 increase in Capital

$3,100 $2,000 beginning O. E. + $1,100 increase = Jessica Jane’s Campus Delivery Statement of Owner’s Equity For Month Ended June 30, 20-- Jessica Jane, capital, June 1, 20-- $2,000 Net Income for June $1,250 Less withdrawal for June 150 Increase in Capital 1,100 Jessica Jane, capital, June 30, 20-- $3,100 $2,000 beginning O. E. + $1,100 increase = $3,100

BALANCE SHEET Confirms the accounting equation has remained in balance Includes: Assets, Liabilities, Owner’s Equity

Jessica Jane’s Campus Delivery Balance Sheet June 30, 20-- Balance Sheet reports Assets, Liabilities and Owner’s Equity on a SPECIFIC DATE, Not a period of time

Jessica Jane’s Campus Delivery Balance Sheet June 30, 20-- Assets Liabilities Cash $ 370 Accounts Payable $1,800 Accounts Receivable 650 Owner’s Equity Supplies 80 Prepaid Insurance 200 Jessica Jane, Capital 3,100 Delivery Equipment 3,600 Total Liabilities and Total Assets $4,900 Owner’s Equity $4,900 It Balances!!!