CHAPTER ONE ANALYZING TRANSACTIONS The Accounting Equation

CHAPTER ONE ANALYZING TRANSACTIONS: The Accounting Equation

BUSINESS ENTITY Ø An individual, association, or organization Ø That engages in economic activities Ø And controls specific economic resources Ø 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 EXAMPLES: 4 CASH 4 MACHINERY 4 MERCHANDISE 4 BUILDINGS 4 FURNITURE 4 LAND 4 FIXTURES 4 ACCOUNTS RECEIVABLE 4 Can chickens be an asset?

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

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

LIABILITIES EXAMPLES: 4 ACCOUNTS PAYABLE (short term credit) 4 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 Ø Formal written promises to pay suppliers or lenders Ø Specific sums of money at definite future times

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

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 $100, 000 $60, 000 = $40, 000 Can also be expressed as: Assets = Liabilities + Owner’s Equity

BUSINESS ENTITY CONCEPT Ø Owner may have business assets and liabilities and personal assets and liabilities. Ø 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: Assets

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

BUSINESS TRANSACTION Ø An economic event that has a direct impact on the business Ø Usually requires an exchange with an outside entity Ø Must be able to measure this exchange in dollars Ø 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.

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 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

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

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

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

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

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 CASH SUPPLIES ASSET

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

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

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

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

Transaction #3 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 LIABILITY ASSET

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

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

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

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

EXAMPLE Mary made a $400 payment on the copy machine she bought earlier. -00 400. 0 Four Hundred ---0

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

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

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

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

**You should be listening to a recorded lecture right now about how the owner equity items affect owner’s equity. TOTAL Owner’s Equity These cause Owner’s Equity to DECREASE: EXPENSES DRAWING These cause Owner’s Equity to INCREASE: REVENUES INVESTMENTS

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

EXPENSES Ø Represent the decrease in assets as a result of efforts made to produce revenues Ø Separate accounts are maintained for each type of expense EXAMPLES: è Rent è Salaries è Supplies Consumed è 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. . .

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

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 $8, 000 $9, 500 = NET LOSS = ($1, 500) $3, 500 + $3, 000 + $2, 500

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

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

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

QUESTION #3 b Does transaction balance? ASSETS = LIAB. CASH = +$4, 500 = + OWNER’S EQUITY CONSULT. FEES +$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 $3, 000 BAL. $23, 800 $800 + $4, 500 BAL. $28, 300 $3, 000 $800 $32, 100

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

EXPENSE EXAMPLE Mary paid her assistant $750 in wages

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

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

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

Right Side of the Accounting Equation: LIAB. OWNER’S EQUITY ACCTS. + M. A. , + REV. - EXPENSES PAY. CAPITAL $4, 500 $25, 000 BAL. $2, 600 + $750 BAL. $2, 600 $25, 000 $4, 500 $750 $2, 600 + $25, 000 + $4, 500 $31, 350 $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 Which accounts were affected? ACCOUNTS RECEIVABLE ASSET CONSULTING FEES O. E. REVENUE

QUESTION #3 b Does transaction balance? ASSETS = LIAB. ACCTS. = RECEIVABLE +$6, 000 = + OWNER’S EQUITY CONSULT. FEES +$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 ASSET ACCOUNTS RECEIVABLE ASSET

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

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 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? CASH ASSET M. A. , DRAWING O. E. DRAWING

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