FINANCIAL ACCOUNTING

BASICS

G. Transaction Analysis

H. Balance Sheet Changes

I. Accounting Conventions

Practice Exercise - at the end of Part Two there is an exercise that you should complete before proceeding to Part Three

(Once you have completed this exercise, you can compare your results with the solution available on

Blackboard)

G. TRANSACTION ANALYSIS

Every business transaction can be analyzed in terms of its effect on

Assets, Liabilities, and Equity. What combinations are possible,

given that the balance sheet equation must remain in balance?

A = L + E Sample Transaction

1. + + • Company borrows cash from bank (+ Cash, + Bank Loan Payable) • Purchases inventory on account (+ Inventory, + Account Payable)

2. + + • Investors purchase common stock from company (+ Cash, + Common Stock)

3. +, -

• Cash purchase of equipment (+ Equipment, - Cash)• Collection of account receivable (+ Cash, - Accounts Receivable)

G. TRANSACTION ANALYSIS (cont)

5. - - • Company pays dividend to stockholders (- Cash, - Retained earnings)

6. + - • Company purchases stock from stockholder, will pay in future (- Common Stock, + Payable to Stockholder)

4. - - • Company pays bank loan (- Loan Payable, - Cash)• Pays account payable to supplier (- Account Payable, - Cash)

A = L + E Sample Transaction

7. - + • Liability is converted into equity investment, e.g., convertible bonds are converted into common stock (- Bonds Payable, + Common Stock)

G. TRANSACTION ANALYSIS (cont)

8. +,-

• Company incurs new liability to pay existing liability, e.g., account payable to supplier is converted into long-term note payable (- Account Payable, + Note Payable)

Combinations 1 – 5 are most common; 6 – 9 are rare

A = L + E Sample Transaction

9. +,-

• Company distributes stock dividend to stockholders (+ Common Stock, - Retained Earnings)

Next, we will analyze the effect that each of a series of transactions has on a company’s balance sheet.

H. BALANCE SHEET CHANGES

ABC CompanyBalance Sheet

January 2, Year 1

Assets Liabilities and Equity

Assets Liabilities and Equity

Cash $10,000 Paid-in capital $10,000 Total $10,000 Total $10,000

2. On January 3, ABC Company borrows $5,000 from Multi Bank.

ABC CompanyBalance Sheet

January 3, Year 1

Cash $15,000 Note payable $ 5,000 Paid-in capital 10,000Total $15,000

Total $15,000

1. On January 2, owners invest $10,000 in ABC Company to begin the business.

H. BALANCE SHEET CHANGES (cont)3. On January 5, ABC Company purchases $8,000 of inventory from suppliers, on

account. Payment will be made on January 10.

ABC CompanyBalance Sheet

January 5, Year 1

Assets Liabilities and Equity

Inventory 8,000

Accounts payable $ 8,000 Cash $15,000

Total $23,000

Note payable 5,000 Paid-in capital 10,000

Total $23,000

4. On January 9, ABC Company sells inventory that cost $2,000 for $2,500 in cash. ABC Company

Balance SheetJanuary 9, Year 1

Assets Liabilities and EquityCash $17,500

Note payable 5,000 Accounts payable $ 8,000

Paid-in capital 10,000Retained earnings 500

Total $23,500

Inventory 6,000

Total $23,500

H. BALANCE SHEET CHANGES (cont)5. On January 10, ABC Company pays for inventory purchased on January 5.

6. On January 12, ABC Company sells inventory that cost $4,000 for $5,000, on account. Payment will be received on January 31.

ABC CompanyBalance Sheet

January 12, Year 1

ABC CompanyBalance Sheet

January 10, Year 1

Assets Liabilities and Equity

Assets Liabilities and Equity

Cash $ 9,500 Inventory 6,000

Total $15,500

Note payable $ 5,000 Paid-in capital 10,000

Retained earnings 500

Total $15,500

Cash $ 9,500

Accts receivable 5,000 Inventory 2,000

Total $16,500

Note payable $ 5,000

Paid-in capital 10,000

Retained earnings 1,500

Total $16,500

H. BALANCE SHEET CHANGES (cont)7. On January 31, ABC Company collects the account receivable in cash.

ABC CompanyBalance Sheet

January 31, Year 1

Assets Liabilities and EquityCash $14,500

Inventory 2,000

Total $16,500

Note payable $ 5,000Paid-in capital 10,000

Retained earnings 1,500Total $16,500

I. ACCOUNTING CONVENTIONS

1. Preparing a new balance sheet after each transaction is cumbersome. 2. Instead, changes in balance sheet amounts are reflected in “accounts”. 3. Any balance sheet account can be increased and decreased. 4. Accountants often use “T accounts” to summarize the effects of transactions. 5. The Cash T account for ABC Company is shown below.

+ Cash -

Balance, Jan 1 01. Jan 2 10,0002. Jan 3 5,0004. Jan 9 2,500

8,000 5. Jan 107. Jan 31 5,000

22,500 8,000

Balance, Jan 31 14,500

I. ACCOUNTING CONVENTIONS

6. Accounting Conventions a. Assets (including cash) are: increased by making entries

on the left side of the account and

decreased by making entries on the right side of the account

b. Liabilities and equity are: increased by making entries

on the right side of the account and

decreased by making entries on the left side of the account

Assets = Liabilities + Equity

+ - - + - +

c. If right side entries equal left side entries when each transaction is recorded, then A = L + Ed. Left side entries are called debits and right side entries are called

creditse. To make sure that A = L + E after each transaction, for each

transaction debits must equal credits

PRACTICE EXERCISE

On the next page, make the “T-account” entries necessary to account for transactions 1 - 7.

For each entry, make sure that debits equal credits.

PRACTICE EXERCISE (cont)

Cash Inventory

Note Payable

Paid-in Capital Retained Earnings

Accounts Receivable

Accounts Payable

End of Part Two