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CHAPTER 2: ACCOUNTING FOR TRANSACTIONSI.FINANCIAL STATEMENTSA. Income Statement Describes a company’srevenues and expensesalong with theresulting net income orloss over a period oftime due to earningsactivities. Examples of accountson form: Consultingrevenue, rentalrevenue, advertisingexpense, rent expense, salaries expenseB. Statement of Retained Earnings Explains changes in retained earnings from net income (or loss) and from anydividends over aperiod of time. Examples ofaccounts on form:retained earningsfor April 1, 2009,Net Income or (netloss), Dividends,retained earningsfor April 30, 2009Financial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 1

C. Balance Sheet Describes a company’sfinancial position (typesand amounts of assets,liabilities, and equity) at apoint in time. Examples of accounts onform: assets like cash,accounts receivable,supplies, equipment;liabilities like accountspayable; equity likecommon stock andretained earningsD. Statement of Cash Flows Identifies cash inflows(receipts) and cash outflows(payments) over a period oftime. Has three sections: 1st sectionon cash flows from OperatingActivities, 2nd section reportsInvesting Activities, and the3rd section shows cash flowsfrom Financing Activities. Examples of accounts onform: cash from operatingactivities, purchase ofequipment, investments bystockholder, dividends tostockholderFinancial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 2

II. TRANSACTION ANALYSIS AND THE ACCOUNTING EQUATIONA. Accounting Equation1. Assets Resources owned or controlled by a company. Examples: cash, accounts receivable, supplies,equipment, and land These resources are expected to yield future benefits Examples: musical instruments for a rock band, landfor a vegetable grower Receivable—is an asset that promises a future inflowof resources. A company that provides a se rvice or product “on credit’ is said tohave an account receivable from that customer.2. Liabilities What a company owes to its creditors in futurepayments, products, or services. Payable—means a liability that promises afuture outflow of resources. Examples: wages payable to workers, accounts payable to suppliers, notes payable tobanks, taxes payable to the government3. Equity Is the owner’s claim on assets. It is the owner’s actual interest in the business. Also called “net assets” or “residual equity”. Can be found by subtracting total assets from total liabilities.Financial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 3

Corporation’s equity is called stockholders’ equity or shareholders’ equity. Revenues—increase in company resources from the sale of goods or services. Examples: consulting se rvices provided, sales of products, facilities rented toothers, commissions from services Expense—costs encountered in the normal course of business. Examples: costs of employee time, use of supplies, advertising from others, utilitiesfrom others Net Income—an overall measure of performance for the period which equals revenuesless expenses.4. Equationa. Basic Accounting Equation Assets Liabilities Equity Assets must be equal to the claimsagainst those assets. If you have an asset, we can have twobroad categories of claims against that asset. First, we may have claims by creditors, liabilities. Secondly, after all creditor claims are satisfied, owners and stockholders have aclaim on those assets.b.Assets -Financial Accounting Fundamentals, Ch. 2, Wild, 2009.Liabilities- Equity- Page 4

Expanded Accounting EquationCommon stock—when an ownerinvests in a companyin exchange forcommon stock. Dividends—a corporation’s distribution of assets to its owners; it reduces theequity account.B. Transaction Analysis Business activities can be described in termsof transactions and events. Events—are happenings that affect anentity’s accounting equation AND can bereliably measured. Examples: changes in the market value of certain assets and liabilities,natural events such as floods and fires that destroy assets and createlosses During the process of recording business transactions, itis IMPORTANT to always keep the accounting equation inbalance. We can’t let our books get out of balance.III. ANALYZING AND RECORDING PROCESS The accounting process identifies business transactionsand events, analyzes and records their effects, andsummarizes and presents information in reports andfinancial statements. External transactions—where external parties likecreditors, customers, financial institutions and ownershave exchanges of value between the two entities.Financial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 5

Internal transactions—transactions that may involve exchanges between divisions within acompany or payments to employees. The analyzing and recording process consists of:1. Analyze each transaction and event from sourcedocuments2. Record relevant transactions and events in a journal3. Post journal information to ledger accounts4. Prepare and analyze the trial balanceA. Source Documents Identify and describe transactions and eventsentering the accounting process. Provide objective and reliable evidence abouttransactions and events and their amounts. Can be in hard copy form or in electronicform. Examples: sales tickets, checks, purchaseorders, bills from suppliers, employee earnings records, and bank statementsB. The Account and Its Analysis Account—a record of increases and decreases in a specific asset, liability, equity,revenue, or expense item. Account information is analyzed, summarized, and presented in reports and financialstatements. General Ledger (or ledger)—is a record containing all accounts used by a company. Accounts are arranged in three general categories based on the accounting equation: 1.Assets, 2. Liabilities, 3. EquityFinancial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 6

1. Asset Accounts Assets—are resources owned or controlled by a company and that have expectedfuture benefits. Examples: cash, accounts receivable, note receivable (or promissory note), prepaidaccounts, supplies, equipment, buildings, landa. Cash Reflects a company’s cash balance. All increases and decreases in cash are recorded in this account. Examples: money and any medium of exchange that a bank acceptsfor deposit (coins, checks, money orders, and checking accountbalances)b. Accounts Receivable Also called credit sales or sales on account (or on credit). Are promises of payment from customers to sellers. Customers charge the item with the seller, get to take the item home and payfor it later. Account receivables are increased by credit sales. Account receivables are decreased when customers make payments.c. Note Receivable (or Promissory Note) Is a written promise of another person to pay a definite sum of money on aspecified future date to the holder of thenote. A company that is holding a promissorynote signed by another person (entity) hasan asset that is recorded in a Note (orNotes) Receivable account.Financial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 7

d. Prepaid Accounts (also called Prepaid Expenses) Are assets that represent prepayments of FUTURE expenses (NOT currentexpenses). When the expense finally happens through the passage of time or are used up,the amounts in prepaid accounts are transferred to expense accounts. Examples: prepaid insurance, prepaid rent, prepaid services (such as clubmemberships) Prepaid accounts are adjusted when the financial statements are prepared sothat: (1) all expired and used prepaid accounts are recorded as regularexpenses and (2) all unexpired and unused prepaid accounts are recorded asassets. Example: a premium is an insurance fee that is paid in advance for a certainlength of time (i.e. one year). It is listed as Prepaid Insurance and is an assetfor the insurance coverage that we have paid for in advance but haven’t usedyet. Once we use up a month’s worth of insurance, it is deducted from theworth of Prepaid Insurance (an asset) and is recorded as an expense.e. Supplies Are considered assets until they are used. When used up, their costs are reported as expenses. Are grouped by purpose —Office Supplies, Store Supplies Office Supplies includes stationery, paper, toner, pens. Store Supplies includes packaging materials, plastic and paperbags, gift boxes and cartons, cleaning materials.f. Equipment Is an asset. Are grouped by purpose —Office Equipment, Store Equipment Office Equipment includes computers, printers, desks, chairs, andshelves.Financial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 8

Store Equipment includes counters,showcases, ladders, hoists, and cash registersg. Buildings Are assets because they provide expected future benefits to those who controlor own them. Examples: stores, offices, warehouses,and factories Separate accounts are sometimes kept when a business owns several buildings.h. Land The cost of land owned by a business is recorded in a Landaccount. Buildings on that land are recorded in a Building account.2. Liability Accounts Are claims by creditors against assets; obligations to transfer assets orprovide products or services to other entities/companies. Creditors—individuals and organizations that own the right to receivepayments from a company. It’s when your business charges items with another company and still owes themoney. If your business fails to pay the company (creditor) money when it is due, the creditorhas a legal right to take your assets, sell them and pay for your debt. Examples: Accounts Payable, Note Payable, Accrued Liabilitiesa. Accounts Payable Oral or implied promises to pay later, which usually happens from purchases ofmerchandise on account.Financial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 9

It can also happen from purchases of supplies, equipment, and services.b. Notes Payable A formal promise, usually indicated by the signing of a promissory note, to pay afuture amount. Depending on when it is to be paid, it can be recorded either to a short-term NotePayable account or a long-term Note Payable account.c. Unearned Revenue Revenue—also called sales Is when the cash has been received but the product or service has not beendelivered. Example: you subscribe to a magazine, you pay a one -year subscription inadvance. The publishing company has received cash butnothing has been done to earn that revenue. As the magazineis delivered to you, the publishing company recognizes aportion of the money received as revenue. At the end of theyear, all the revenue will be earned and the liability no longerexists.d. Accrued Liabilities Amounts owed that are not yet paid. Examples: Wages Payable, Taxes Payable, Interest Payable3. Equity Accounts Also called stockholders’ equity, or shareholders’ equity Is the owner’s claim on a corporation’s assets. Equity is the owners’ remaining interest in the assets of a business after deductingliabilities.Financial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 10

Equity is affected by four accounts: common stock, dividends, re venues, andexpenses.a. Common Stock When an owner invest in a company in exchange for ashare/stock in the company. Increases equity.b. Dividends Opposite of owner investment anddecreases equity. It’s the distribution of assets to thestockholders. Is an account used in recording assetdistribution to stockholders/owners.c. Revenues When products and services are sold or provided to customers. Increases equity. Examples: Sales, Commissions Earned, Professional Fees Earned, RentEarned, Interest Revenued. Expenses Result from assets and services used in a company’s operation. Decreases equity. Examples: Advertising Expense, Store Supplies Expense, Office SalariesExpense, Office Supplies Expense, Rent Expense, Utilities Expense, InsuranceExpenseFinancial Accounting Fundamentals, Ch. 2, Wild, 2009.Page 11