Download 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)
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
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
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
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
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:
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
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 #2a
Identify accounts that are affected
CASH
M. A.
CAPITAL
QUESTION #2b
Classify these accounts
CASH
ASSET
M. A.
CAPITAL
OWNER’S
EQUITY
QUESTION #3a
Determine whether the accounts
have increased or decreased
CASH
M. A.
CAPITAL
QUESTION #3b
Does accounting equation balance?
ASSETS = LIABILITIES
+ OWNER’S EQUITY
CASH =
+$25,000 =
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
ASSET
QUESTION #3a
Increase or Decrease?
OFFICE
SUPPLIES
ASSET
CASH
ASSET
QUESTION #3b
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 #3b
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 ourAccounting Equation in Balance
after both transactions?
= LIAB.
ASSETS
CASH
a.
b.
$25,000
-800
bal
$24,200
+
OFF. SUPPLIES
+
O. E.
M. A.,CAPITAL
=
$25,000
+800
$800
$25,000
$25,000
= $0
Yes!
Total 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 #3a
Increase or Decrease?
EQUIP.
ASSET
ACCOUNTS
PAYABLE
LIABILITY
QUESTION #3b
Let’s look at the accounting equation:
ASSETS = LIABILITIES
+ OWNER’S EQUITY
EQUIP. = ACCOUNTS
PAYABLE
+ $3,000
+ $3,000 =
This transaction had
no effect on
Owner’s Equity
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?
= LIAB.
ASSETS
CASH
a.
b.
+ OFF. SUPPLIES + Equip. =
25,000
-800
bal
24,200 +800
$28,000
+3,000
=
+3,000
=
=
O. E.
M. A.,CAPITAL
25,000
=
+800
c.
Accts. payable
+
+3,000
25,000
$3,000
+ $25,000
EXAMPLE
Mary made a $400 payment on the copy
machine she bought earlier.
400.00
QUESTIONS #1 & #2
Understand the transaction,
Identify and Classify the affected
accounts
CASH
ACCOUNTS
PAYABLE
LIABILITY
ASSET
QUESTION #3a
Increase or Decrease?
CASH
ASSET
ACCOUNTS
PAYABLE
LIABILITY
QUESTION #3b
Let’s look at the accounting equation:
ASSETS = LIABILITIES
+ OWNER’S EQUITY
CASH = ACCOUNTS
PAYABLE
- $400
- $400 =
This transaction had
no effect on
Owner’s Equity
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
**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
EXAMPLES:
 Delivery Fees
Record ALL
EARNED
revenue!!
 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
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. . .
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 + $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 + $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.
QUESTIONS #1 & #2
The two accounts effected are:
CASH
CONSULTING
FEES
(ASSET)
(OWNER’S
EQUITYREVENUE)
QUESTION #3b
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.
BAL.
BAL.
$2,600
$2,600
OWNER’S EQUITY
M. A., CAPITAL + CONSULTING. FEES
$25,000
$25,000
$32,100
+ $4,500
$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
QUESTION
#3bgo 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 $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
Which accounts were affected?
ACCOUNTS
RECEIVABLE
CONSULTING
FEES
ASSET
O.E. REVENUE
QUESTION #3b
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 #3b
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 #3b
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