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)

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

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  MERCHANDISE  FURNITURE  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

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

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

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).

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

ACCOUNTING EQUATION AssetsLiabilities=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.

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

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

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

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

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

QUESTION #3b Does accounting equation balance? ASSETS= LIABILITIES + OWNER’S EQUITY +$25,000 CASH M. A.,CAPITAL= +$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

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

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

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

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

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

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 ASSETLIABILITY INCREASED

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

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

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

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

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 ASSETLIABILITY DECREASED

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

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

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

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

OWNER’S EQUITY TRANSACTIONS FOUR TYPES: DECREASE: EXPENSES DRAWING INCREASE: REVENUES 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: è Delivery Fees è Consulting Fees è Rent Revenue (if business rents space to others) è Interest Revenue (for interest earned on bank deposits) èSales (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: è Rent è Salaries è Supplies Consumed è Taxes

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. REVENUEEXPENSES = NET INCOME $6,000$5,000 = $1,000 $1,500 + $500 + $3,000

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. REVENUEEXPENSES = NET LOSS $8,000$9,500 = ($1,500) $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

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

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

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

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 INCREASE DECREASE

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

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

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

PROVING ACCOUNTING EQUATION BALANCES: LIAB.OWNER’S EQUITY ACCTS. PAY. M. A., CAPITAL $25,000 BAL. $2,600 $2,600 + $25,000 + $4,500 $750 = $31,350 REV. BAL. $2,600 $25,000 $4,500 EXPENSES + $750 $750

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 INCREASE

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

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

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

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 CASHACCOUNTS RECEIVABLE ASSET

QUESTION #3a Increase or Decrease? CASH ACCOUNTS RECEIVABLE INCREASE DECREASE

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

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

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

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 DECREASE

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.

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

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

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

FINANCIAL STATEMENTS  THREE COMMONLY PREPARED FINANCIAL STATEMENTS: oINCOME STATEMENT oSTATEMENT OF OWNER’S EQUITY oBALANCE 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

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

Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- 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 Totals

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

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

Jessica Jane’s Campus Delivery Income Statement For Month Ended June 30, 20-- Revenues: Consulting Fees Expenses: Wages Expense Rent Expense Telephone Expense Total Expenses Net Income $2,150 $ $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 Expenses: Wages Expense Rent Expense Telephone Expense Total Expenses Net Income $2,150 $ $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

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.

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 Less withdrawal for June Increase in Capital $1, ,100 $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 Less withdrawal for June 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 Receivable 650 Supplies 80 Prepaid Insurance 200 Delivery Equipment 3,600 $4,900 Total Assets Accounts Payable Owner’s Equity Jessica Jane, Capital $1,800 3,100 Total Liabilities and Owner’s Equity $4,900 It Balances!!!

ACCOUNTING PROCESS  THREE BASIC PHASES: oInput oProcessing oOutput

INPUT Transactions provide the necessary input

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

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

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