ANALYZING TRANSACTIONS: The Accounting Equation CHAPTER TWO 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

ITEMS OWNED BY A BUSINESS THAT WILL PROVIDE FUTURE BENEFITS ASSETS ITEMS OWNED BY A BUSINESS THAT WILL PROVIDE FUTURE BENEFITS BUT DOESN’T HAVE TO BE PAID OFF, COULD STILL BE MAKING PAYMENTS ON IT

ASSETS EXAMPLES: CASH MACHINERY MERCHANDISE BUILDINGS FURNITURE LAND FIXTURES MACHINERY BUILDINGS LAND ACCOUNTS RECEIVABLE

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

DEBTS OR OBLIGATIONS OF THE BUSINESS THAT CAN BE PAID WITH LIABILITIES PROBABLE FUTURE OUTFLOW OF ASSETS AS A RESULT OF A PAST TRANSACTION OR EVENT IN OTHER WORDS, DEBTS OR OBLIGATIONS OF THE BUSINESS THAT CAN BE PAID WITH CASH, GOODS , OR SERVICES

LIABILITIES EXAMPLES: ACCOUNTS PAYABLE NOTES PAYABLE

ACCOUNTS PAYABLE Unwritten promise to pay a supplier for assets purchased or services rendered referred to as making a purchase “on account” or “on credit” 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

AMOUNT BY WHICH THE BUSINESS ASSETS EXCEED THE BUSINESS LIABILITIES OWNER’S EQUITY AMOUNT BY WHICH THE BUSINESS ASSETS EXCEED THE BUSINESS LIABILITIES ALSO CALLED: NET WORTH CAPITAL OR

the remaining assets belong to the owner (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? Once the debts are paid, the remaining assets belong to the owner (Owner’s Equity).

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 nonbusiness assets and liabilities. Nonbusiness assets and liabilities are not included in the entity’s accounting records. If owner invests money or other assets in the business, the item is now a business asset

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

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.

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

ANALYZING BUSINESS TRANSACTIONS THREE QUESTIONS:

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 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 INCREASED INCREASED

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

EXAMPLE: PURCHASED OFFICE SUPPLIES FOR $800 CASH

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 INCREASED DECREASED

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. =  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

PROVING ACCOUNTING EQUATION BALANCES: ASSETS: CASH OFFICE SUPPLIES $25,000 - $800 $800 BALANCE $24,200 $800 LEFT SIDE OF EQUATION: CASH $24,200 SUPPLIES $ 800 TOTAL ASSETS $25,000

PROVING ACCOUNTING EQUATION BALANCES: LIABILITIES OWNER’S EQUITY $ 0 $25,000 BALANCE BALANCE $ 0 $25,000 RIGHT SIDE OF EQUATION: $ 0 LIABILITIES OWNER’S EQUITY $25,000 TOTAL LIAB. & O.E. $25,000

PURCHASED EQUIPMENT ON ACCOUNT FOR $3,000 EXAMPLE PURCHASED EQUIPMENT ON ACCOUNT FOR $3,000

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts Mary is buying this copy machine “on account.” She will be making payments on it over the next few years. NO CASH WAS EXCHANGED 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 INCREASED INCREASED

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

PROVING ACCOUNTING EQUATION BALANCES: ASSETS: CASH + + SUPPLIES EQUIPMENT $25,000 - $800 $800 BAL. $24,200 $800 +$3,000 BAL. $24,200 $800 $3,000 SUPPLIES $ 800 $24,200+$800+$3,000= $28,000 TOTAL ASSETS $25,000

PROVING ACCOUNTING EQUATION BALANCES: LIABILITIES OWNER’S EQUITY ACCTS. PAY. M. A., CAPITAL +$25,000 BAL. $25,000 +$3,000 $3,000 $25,000 BAL. $3,000 + $25,000 =$28,000 TOTAL LIAB. & O. E.

MADE $400 PAYMENT ON EQUIPMENT EXAMPLE MADE $400 PAYMENT ON EQUIPMENT

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 DECREASED DECREASED

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

PROVING ACCOUNTING EQUATION BALANCES: ASSETS: CASH SUPPLIES EQUIPMENT $25,000 - $800 $800 BAL. $24,200 $800 +$3,000 BAL. $24,200 $800 $3,000 -$400 SUPPLIES BAL. $23,800 $800 $3,000 $27,600

PROVING ACCOUNTING EQUATION BALANCES: LIABILITIES OWNER’S EQUITY ACCTS. PAY. M. A., CAPITAL +$25,000 $25,000 BAL. +$3,000 $3,000 $25,000 BAL. -$400 $2,600 $25,000 BAL. $27,600

OWNER’S EQUITY TRANSACTIONS FOUR TYPES: DECREASE: INCREASE: EXPENSES REVENUES DRAWING INVESTMENTS

REVENUE Amount a business charges customers for products sold or services performed Recognized when earned (even if cash has not yet been received) Increases both Assets (Cash or Accounts Receivable) and Owner’s Equity

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 Represent the decrease in assets as a result of efforts made to produce revenues Separate accounts are maintained for each type of expense Either decrease assets or increase liabilities, but ALWAYS decrease Owner’s Equity

EXPENSES EXAMPLES: Rent Salaries Supplies Consumed Taxes

$1,000 NET INCOME = = $6,000 $5,000 REVENUE EXPENSES NET INCOME REVENUE Greater than EXPENSES = NET INCOME EXAMPLE: Luke Perkins performed $6,000 of Tax 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 Atwood 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 Say 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 PERFORMED SERVICES AND RECEIVED $4,500 IN CASH

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts CONSULT. FEES CASH O.E. REVENUE ASSET

QUESTION #3a Increase or Decrease? CONSULT. FEES CASH INCREASE

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

PROVING ACCOUNTING EQUATION BALANCES: ASSETS: CASH SUPPLIES EQUIPMENT $23,800 $800 $3,000 BAL. + $4,500 $28,300 $800 $3,000 BAL. $32,100

PROVING ACCOUNTING EQUATION BALANCES: LIAB. OWNER’S EQUITY ACCTS. PAY. M. A., CAPITAL CONSULT. FEES $25,000 $2,600 BAL. + $4,500 BAL. $2,600 $25,000 $4,500 $32,100

MARY ADAMS PAID HER ASSISTANT $750 IN WAGES EXPENSE EXAMPLE MARY ADAMS PAID HER ASSISTANT $750 IN WAGES

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts WAGES EXPENSE CASH O.E. EXPENSE ASSET

QUESTION #3 Increase or Decrease? WAGES EXPENSE CASH DECREASE INCREASE

QUESTION #3 Increase or Decrease? WAGES EXPENSE CASH BE CAREFUL! While incurring an expense will increase the Expense account, it will cause an overall DECREASE IN OWNER’S EQUITY.

Does transaction balance? Owner’s Equity decreased by $750 QUESTION #3b 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

PROVING ACCOUNTING EQUATION BALANCES: ASSETS: CASH SUPPLIES EQUIPMENT $28,300 $800 $3,000 BAL. - $750 BAL. $27,550 $800 $3,000 $31,350

PROVING ACCOUNTING EQUATION BALANCES: 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!

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts CONSULT. FEES ACCOUNTS RECEIVABLE O.E. REVENUE ASSET

QUESTION #3a Increase or Decrease? CONSULT. FEES ACCOUNTS RECEIVABLE

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

PROVING ACCOUNTING EQUATION BALANCES: ASSETS: CASH ACCTS. REC. SUPPLIES EQUIP. $27,550 BAL. $800 $3,000 + $6,000 $27,550 $6,000 $800 $3,000 BAL. $37,350

PROVING ACCOUNTING EQUATION BALANCES: LIAB. OWNER’S EQUITY ACCTS. PAY. M. A., CAPITAL REV. EXPENSES $2,600 $25,000 $4,500 $750 BAL. + $6,000 BAL. $2,600 $25,000 $10,500 $750 $2,600 + $25,000 + $10,500 $750 = $37,350

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 #3a Increase or Decrease? CASH ACCOUNTS RECEIVABLE DECREASE

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

PROVING ACCOUNTING EQUATION BALANCES: ASSETS: CASH ACCTS. REC. SUPPLIES EQUIP. $27,550 $6,000 $800 $3,000 BAL. +$2,500 -$2,500 $30,050 $3,500 $800 $3,000 BAL. $37,350

PROVING ACCOUNTING EQUATION BALANCES: LIAB. OWNER’S EQUITY ACCTS. PAY. M. A., CAPITAL REV. EXPENSES $2,600 $25,000 $10,500 $750 BAL. BAL. $2,600 $25,000 $10,500 $750 No Change to Right Side of Equation. Still = $37,350

DRAWING EXAMPLE: MARY WITHDREW $1,500 FOR PERSONAL EXPENSES

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 reduce the Assets & reduce her Owner’s Equity.

QUESTIONS #1 & #2 Understand the transaction, Identify and Classify the affected accounts M. A., DRAWING CASH O.E. DRAWING ASSET

QUESTION #3a Increase or Decrease? M. A., DRAWING CASH INCREASE

QUESTION #3a Increase or Decrease? M. A., DRAWING CASH BE CAREFUL! Just like Expenses, Drawing account will increase in this situation, but it will cause an overall DECREASE IN OWNER’S EQUITY.

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

PROVING ACCOUNTING EQUATION BALANCES: ASSETS: CASH ACCTS. REC. SUPPLIES EQUIP. $30,050 $3,500 BAL. $800 $3,000 -$1,500 $28,550 $3,500 $800 $3,000 BAL. $35,850

PROVING ACCOUNTING EQUATION BALANCES: LIAB. OWNER’S EQUITY ACCTS. PAY. M. A., CAP. M. A., DRAWING REV. EXP. $2,600 $25,000 $10,500 $750 BAL. +$1,500 BAL. $2,600 $25,000 $1,500 $10,500 $750 $2,600 + $25,000 - $1,500 + $10,500 -$750 = $35,850

FINANCIAL STATEMENTS THREE COMMONLY PREPARED FINANCIAL STATEMENTS: INCOME STATEMENT STATEMENT OF OWNER’S EQUITY BALANCE SHEET

INCOME STATEMENT Reports the profitability of business operations for a specific period of time. Expenses are subtracted from Revenues to determine Net Income/Loss. Also called Profit and Loss Statement or Operating Statement

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 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 withdrawal 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 Also called Statement of Financial Position or Statement of Financial Condition

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!!!

ACCOUNTING PROCESS THREE BASIC PHASES: Input Processing Output

Transactions provide the necessary input

PROCESSING Identify accounts Classify accounts Increase or Decrease? Enter transaction and verify balance

STATEMENT OF OWNER’S EQUITY OUTPUT INCOME STATEMENT STATEMENT OF OWNER’S EQUITY REVENUES BEGINNING CAPITAL plus minus INVESTMENTS EXPENSES plus equals NET INCOME minus NET INCOME WITHDRAWALS equals ENDING CAPITAL

OWNER’S EQUITY (Ending Capital) OUTPUT BALANCE SHEET ASSETS equal LIABILITES plus OWNER’S EQUITY (Ending Capital)