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Chapter 1 The Nature of Accounting by EHYMl7

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									            Chapter 1 BASIC ACCOUNTING IN ACTION

I. Overview of Accounting.
        A. Define accounting.
               1. Accounting is considered the language of business. This is because in
                   today’s business world it is impossible to get by without accounting. Every
                   organization—whether profit making or not-for-profit—must make good
                   decisions in order to survive. Accounting provides information that is the
                   basis for making those decisions.
               2. Definition of Accounting: The Accounting Process as the process of
                   Analyzing (Identifying business transactions); Classifying); (Determining
                   the specific accounts involved and deciding whether the accounts should be
                   increased or decreased); Recording (Listing the details in a permanent record
                   (either in writing or electronically); Summarizing (After a period of time,
                   showing the results of a group of transactions in the form of financial
                   statements); and Interpreting (Drawing conclusions and making decisions
                   from financial statements). Notice how the process in illustrated in a circular
                   pattern because accounting is performed in cycles. Once a cycle is complete,
                   the process begins all over again. Note the distinction between Accounting
                   and Bookkeeping where bookkeeping involves just the recording element of
                   the accounting process and accounting involves classifying, analyzing,
                   interpreting accounting data.
               3. Accounting also provides Economic Information which means it is
                   providing information dealing with financial or money-related activities to
                   permit individuals and organizations to make informed judgments and
                   decisions.
               4. Identify users of accounting. Some questions asked by internal and
                   external users of accounting data:
                   a) Internal users of accounting information are managers who plan,
                       organize, and run a business.
                   b) External users include investors (owners) who use accounting
                       information to make decisions to buy, hold, or sell stock and creditors
                       such as supplies and bankers who use accounting information to evaluate
                       the risks of granting credit or lending money.
        B. History of Accounting—the double-entry system of accounting that is the basis of
           our modern accounting system was first introduced in 1494 by an Italian monk
           named Luca Pacioli who was a mathematician. He published a mathematics book
           where he devoted a couple of chapters in that book to the double-entry system of
           accounting during a period of time when merchants were making expeditions.
           Explorations were accomplished by obtaining funding from various sources
           sponsoring the expeditions. Along with the funding, there would be a need to
           account for the funds that were used on these voyages which accounts for the timing
           of the publishing of the double-entry system of accounting. Pacioli did not invent
           the double entry accounting system. He was simply the first to describe it in print.
           Therefore he has the distinction of being called the Father of Accounting.



                                              1
          C. II. The Accounting Equation.
    A. The system of accounting for a business begins by asking the questions: What are the
       resources of a business? Where do the resources come from?

   WHAT ARE THE RESOURCES OF A BUSINESS?                                              WHERE DO THE RESOURCES COME FROM?




                          ASSETS                             =                                            EQUITIES
 (The cost of everything that a business owns or controls)                            (Those who have claims or rights to the assets)




                                                                            Creditors                       +                Owners



                          ASSETS                             =             LIABILITIES                      +              OWNER'S EQUITY

              Accounts                                                Accounts                   Notes                                   -
Cash     +   Receivable    +   Supplies    +    Equipment    =        Payable           +       Payable     +    Capital    + Revenues   Expenses

         +                 +               +                 =                              +               +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +

         +                 +               +                 =                          +                   +
Total
assets                                                               Total equities


               1. The resources of a business are the ASSETS—the cost of everything that a
                  business owns or controls. Examples include cash (includes currency, coins,
                  checks, and money orders made payable to the business); accounts receivable (the
                  asset that comes from selling goods or services on credit to customers); supplies
                  (short-term physical assets needed to operate a business); equipment (long-term
                  physical, tangible assets needed bys a business in order to operate. Look at the key
                  phrases in the definition of assets::
                        a) Cost—the item must have a dollar value to be recorded in the accounting
                            records.
                        b) Owned or controlled by a business—it must belong to the business or
                            under the possession (control) of a business (for example an asset may not


                                                                 2
                     be totally paid for at the present but it is in the control of the business so it
                     is still considered an asset).
         2. The resources come from the EQUITIES of a business—those who have the rights
            or claims to the assets where there are two categories of those having rights or
            claims to the assets:
                  a) Creditors—a business or person to whom a debt is owed. The creditors
                     claim fall under the classification called LIABILITIES which are debts
                     owed by the business. Two examples of liabilities are accounts payable
                     (the liability that results from purchasing goods or services on credit
                     usually short-term from 30 to 90 days) and notes payable (a formal written
                     promise to pay a specified amount at a definite future date).
                  b) Owners—the residual (remaining) claim or right to the assets is from the
                      owner of the business. This claim falls under the classification called
                      OWNER’S EQUITY (for a corporation the owners are called
                      “stockholders” and therefore this category is called STOCKHOLDERS’
                      EQUITY) which is the excess of assets over liabilities (also called capital,
                      proprietorship, and net worth). The owner(s) has (have) claim to the assets
                      that the owner contributed (invested) into the business which falls under the
                      account called capital and the owner has the right or claim to the resources
                      (assets) that are generated from the operations of the business that comes
                      from revenue (income earned from carrying out the activities of a firm).
                      Notice on the handout that expenses are also under the owner’s equity
                      classification as well as they are the costs of operating a business and hence
                      they have a minus sign in front of them as they reduce the amount of
                      income coming from the operations of the business and so reduce the
                      owner’s equity that comes from the operations of the business.
  B. The accounting equation which shows the relationship between the accounting elements
     is first set-up Assets = Equities where the resources of the business are shown on the left
     side of the equation and the rights or claims to those assets are shown on the right side of
     the equation. Then the accounting equation is expanded to show the two types of claims to
     the assets and therefore shows Assets = Liabilities + Owner’s Equity (for a
     corporation, this is called Stockholders’ Equity). If two elements of the accounting
     equation are known, the third can always be found. For example the equation can be
     arranged as follows to determine the missing item:

               Assets      =      Liabilities          +        Owner’s Equity
               Assets      -      Liabilities          =        Owner’s Equity
               Assets      -    Owner’s Equity         =          Liabilities

  For example to find the following missing parts, you would solve as follows:
 Assets             Liabilities                  Owner’s Equity
$36,000              $16,420                         $______
$______              $19,950                          $20,560
$69,860              $______                          $40,290



                                                 3
       Assets        -      Liabilities      =          Owner’s Equity

     $36,000         -       $16,420         =            $19,580
       Assets        =      Liabilities      +          Owner’s Equity

      $40,510        =     $19,950           +              $20,560
       Assets        -   Owner’s Equity      =             Liabilities

      $69,860         -       $40,290          =               $29,570
C. Accepted concepts and principles are generally accepted accounting principles (GAAP),
   which are rules that govern how accounting personnel measure, process, and report
   financial information. Following are concepts that are specifically covered in Chapter 1:
       1. The entity concept states that the business is separate from its owner(s). So even
           though, for a sole proprietor or a partnership, the business and the owner are not
           separate legal entities, for accounting purposes, the assets and liabilities are
           separated for those that belong personally to the owner and those that are accounted
           for in the business and any other business. Therefore, if an owner has more than one
           business, they are each accounted for in separate sets of records.
       2. The cost principle states that all assets, when purchased, are recorded at their
           actual cost, regardless of market value.
       3. The realization principle states that a business earns (realizes) revenue when goods
           or services are sold to customers, even though cash may not be collected until
           sometime in the future. Along with the concept that revenues are recognized when
           they are earned is also the rule that expenses will be recognized when they are
           incurred which may be a different time than when the cash is paid.
       4. The stable monetary unit concept states that only transaction data that can be
           expressed in terms of money be included in the accounting records.
D. Record transactions in the accounting equation. Note from textbook examples that
   accounts (individual records or subdivisions used to record and summarize information
   related to each asset, each liability, and each aspect of owner’s equity) are entered under
   the respective classification that relates to the business transactions (any activity that
   changes the value of a firm’s assets, liabilities, or owner’s equity. The accounting equation
   must always balance. The effects of every transaction can be stated in terms of increases
   and/or decreases in the basic accounting elements. A particular transaction may affect
   only one side of the equation, but still leave the equation balanced. The steps to recording
   business transactions are as follows where GAAP will be used so that the transactions are
   properly recorded and recognized:
       1. Step 1 in recording business transactions involves the first two parts of the definition
           of accounting which are to analyze and classify the transactions. Refer to the bottom
           of the handout on page 2 for the acronym, ACID for the questions to ask when
           analyzing a transaction:
                 a) What ACCOUNTS are involved? For this handout example, the choices
                     are Cash, Accounts Receivable, Supplies, Equipment, Accounts
                     Payable, Notes Payable, Capital, Revenues, and Expenses. Notice the
                     word is “Accounts” (plural) which means that it will take two or more
                     accounts to keep the accounting equation—A = L + OE—in balance for


                                              4
             any business transactions. The textbook refers to this concept as the dual
             effect because every business transaction has at least two effects on the
             accounting equation. This is the double-entry technique, which ensures
             that after recording a transaction, the accounting equation will still balance.
          b) What are the CLASSIFICATIONS of the accounts? The three
             classifications are always the three elements of the accounting equation—
             Assets, Liabilities, and Owner’s Equity. A particular business transaction
             may under only one classification, two classifications, or all three
             classifications. The dual effect can change elements on both sides of the
             accounting equation or just on one side. A common misconception is that
             the dual effect means that both sides of the accounting are affected by each
             transaction. But as you will see, there are transactions that are totally on
             just one side of the accounting equation.
          c) Are the accounts INCREASED (+)? Or …
          d) Are the accounts DECREASED (-)?
2. Step 2 involves recording the business transactions in permanent records. The
   permanent records will be introduced in Chapter 2 what are the journal and the
   ledger. The first chapter uses the accounting equation format (Chapter 1) and the
   T-account format (Chapter 2) to help grasp the basic concepts of accounting as these
   first two chapters are extremely vital chapters as they are covering the fundamental
   foundation of accounting—the double-entry system of accounting. Now complete
   the handout applying these first two steps in recording the business transactions that
   are listed on the bottom of the handout as follows:
          a) Owner invested $10,000 cash to start a business.
               1. Ask: What Accounts are involved? Cash and Capital. Since the
                   owner invested (supplied) the asset to the company, the owner has the
                   right or claim to the asset. The asset now becomes a business asset
                   and not the owner’s personal asset according to the business entity
                   concept stated above. The dollar amount will be entered under the
                   owner’s capital account to show that the owner made an investment
                   into the company and that the owner has the right or claim or this
                   asset.
               2. Ask: What are the Classifications of these accounts? Cash is an
                   asset and capital is a part of the owner’s equity.
               3. Ask: Are the accounts Increased or Decreased? Cash is increased
                   as there was no cash in the business prior to this transaction and now
                   there is $10,000. So enter +10,000 under the cash column next to
                   letter (a). Also the owner’s capital account is increased so enter
                   +10,000 under the capital column. This transaction can be shown as
                   follows showing the dual effect:
                          A      =      L      +     OE
                           +                          +
               4. After every transaction, you should check to see if the accounting
                   equation is in balance. To do so add up the total assets and the total
                   equities to make sure the accounting equation balances and this can be
                   done as follows:


                                       5
Total                 Assets           =           Equities                   Total
10,000   =           +10,000           =           +10,000            =       10,000

           b) Company purchased $500 supplies on account.
               1. Ask: What Accounts are involved? Supplies and Accounts
                  Payable. The terms “on account” is an indicator that a purchase has
                  been charged on account. The company has established a charge
                  account like at Staples, Office Depot, etc. and will probably be billed
                  once a month or so for purchases made on that account.
               2. Ask: What are the Classifications of these accounts? Supplies are
                  an asset and accounts payable is a liability. A question that often
                  comes up here is why are the supplies an asset and not an expense of
                  doing business? Supplies are considered a prepaid expense and will
                  be expensed as they are used. The key to determining if an
                  expenditure should be classified as an asset or an expense is whether
                  the item provides a future benefit to the business. The supplies may
                  be used over a period of several months and therefore would have a
                  future benefit so they are classified as an asset.
               3. Ask: Are the accounts Increased or Decreased? Both supplies and
                  accounts payable are being increased as there were no supplies or
                  amounts owed to creditors prior to this transaction and now both have
                  increased $500. Therefore enter a +500 under the Supplies column
                  and the Accounts Payable column on the line with the letter (b) This
                  transaction can be shown as follows showing the dual effect:
                         A     =      L      +     OE
                         +             +
               4. Check that the accounting equation is in balance as follows:
Total             Assets              =             Equities                    Total
10,500   =     +10,000+500            =          +500+10,000           =       10,500

             c) Company paid $1,000 rent expense on a building.
                 1. Ask: What Accounts are involved? Cash and Expenses (Rent
                    Expense).Expenses are actually a category and each expense will be
                    given a separate account with the name of the expense for preparing
                    financial statements and for tax purposes where individual expenses
                    must be listed with amounts. For this chapter and for homework
                    purposes, there is a description column next to the owner’s equity
                    section to identify the name of the revenue and the name of the
                    expense for financial statement preparation purposes. Rent expense is
                    considered an expense when just paying the monthly rent as there is
                    no future benefit in that expenditure. If several months of rent were
                    paid for in advance, then there is future benefit and it would be
                    recorded as an asset called Prepaid Rent and expensed as each month
                    amount was used.




                                           6
                 2. Ask: What are the Classifications of these accounts? Cash is an
                    asset and expenses are part of owner’s equity. Expenses decrease
                    owner’s equity (reduces the owner’s claim to assets from generating
                    revenues) and are entered with a minus sign to show that it is
                    decreasing the owner’s equity section of the accounting equation.
                    Another way to look as to why expenses decrease owner’s equity is
                    because cash is paid out (or a debt is created) but nothing goes back
                    into the business in its place. There is no future benefit as with
                    supplies or equipment expenditures.
                 3. Ask: Are the accounts Increased or Decreased? Both the cash and
                    the owner’s equity are decreasing. Note that expenses, themselves,
                    are increasing as did not have expenses before and now do have them.
                    But the owner’s equity is decreasing with the operating expenses to
                    run a business. Therefore, enter a -1,000 under the cash column and a
                    -1,000 under the expenses column on the line with the letter (c). This
                    transaction can be shown as follows showing the dual effect:
                           A     =      L       +    OE
                           -                         -
                 4. Check that the accounting equation is in balance as follows:
Total               Assets            =            Equities                      Total
9,500    =        +9,000+500          =      +500+10,000-1,000          =        9,500

           d) Company purchased $15,000 of equipment paying $2,000 down and
              signing a note for the remainder.
                1. Ask: What Accounts are involved? Equipment, Cash and Notes
                   Payable. This would be a notes payable rather than accounts payable
                   as is a formal written promise to pay. Notice how this transaction
                   takes three accounts. The dual effect means that it takes two or more
                   accounts to enter the transaction and in this case three accounts were
                   involved.
                2. Ask: What are the Classifications of these accounts? Equipment
                   and cash are assets and notes payable is a liability.
                3. Ask: Are the accounts Increased or Decreased? Cash is
                   decreased and entered as a -2,000, equipment is increased +15,000
                   (the cost of the equipment—see cost principle above), and notes
                   payable is increased as did not have a notes payable before the
                   transaction with a +13,000 and now have one column on the line with
                   the letter (d) This transaction can be shown as follows showing the
                   dual effect:
                           A      =      L     +     OE
                          -,+            +
                4. Check that the accounting equation is in balance as follows:
Total               Assets             =             Equities                      Total
22,500   =   +7,000+500+15,000         = +500+13,000+10,000-1,000           =     22,500



                                        7
                e) Company rendered services for cash of $2,500.
                    1. Ask: What Accounts are involved? Cash and Revenues (Fees
                       Earned, Service Revenue, Income from Services, etc.). Revenues
                       are the name of a category that always increase owner’s equity since
                       the owner gets to the claim for the income from carrying out the
                       major activity of a business—which increases the value of the
                       business. The specific type of revenue is given the name of the
                       account to describe it for financial statement purposes such as fees
                       earned, fares earned, service revenue, interest income, rent
                       income, sales, etc.
                    2. Ask: What are the Classifications of these accounts? Cash is an
                       asset and revenues are a part of owner’s equity.
                    3. Ask: Are the accounts Increased or Decreased? Both cash and
                       revenues are being increased and entered with a +2,500 under the
                       Cash and the Revenues column on the line with the letter (e). This
                       transaction can be shown as follows showing the dual effect:
                              A     =      L       +    OE
                              +                          +
                    4. Check that the accounting equation is in balance as follows:
    Total              Assets          =                 Equities                       Total
    25,000    = +9,500+500+15,000 = +500+13,000+10,000+2,500-1,000 = 25,000

               f) Company rendered services billing customers for $5,000.
                    1. Ask: What Accounts are involved? Accounts Receivable and
                       Revenues (Fees Earned, Service Revenue, Income from Services,
                       etc.).The realization principle states that revenues must be
                       recognized when earned even though cash may not be received until
                       later.
                    2. Ask: What are the Classifications of these accounts? Accounts
                       receivable is an asset and revenues are a part of owner’s equity.
                    3. Ask: Are the accounts Increased or Decreased? Both accounts
                       receivable and revenues are being increased Therefore enter a +5,000
                       under the Accounts Receivable column and the Revenues column on
                       the line with the letter (f). This transaction can be shown as follows
                       showing the dual effect:
                              A      =      L       +     OE
                              +                             +
                    4. Check that the accounting equation is in balance as follows:
Total               Assets               =                   Equities                     Total
30,000   = +9,500+5,000+500+15,000 =             +500+13,000+10,000+7,500-         = 30,000
                                                              1,000

                 g) Company paid $250 advertising expense.
                     1. Ask: What Accounts are involved? Cash and Expenses
                        (Advertising Expense).


                                             8
                      2. Ask: What are the Classifications of these accounts? Cash is an
                         asset and advertising expense is a part of owner’s equity..
                         Remember the key to determining if an expenditure should be
                         classified as an asset or an expense is whether the item provides a
                         future benefit to the business. If the advertising expenditure was for
                         a current advertisement which is assumed here with the low cost
                         figure, then there is no future benefit and therefore it would be
                         expensed. If several months advertising were paid for in advance and
                         the problem would need to state that, then there would be a future
                         benefit and would be classified as an asset, Prepaid Advertising and
                         would be expensed as each month passed.
                      3. Ask: Are the accounts Increased or Decreased? Both cash and
                         owner’s equity where the expense is classified under are being
                         decreased by $250. Therefore enter a -250 under the Cash column
                         and the Expenses column on the line with the letter (g).The expenses
                         themselves are increasing as now the total expenses would be 1,250.
                         But the total expenses reduce the owner’s equity by the total 1,250.
                         This transaction can be shown as follows showing the dual effect:
                                A      =      L      +    OE
                                -                         -
                    4. Check that the accounting equation is in balance as follows:
Total               Assets              =               Equities                        Total
29,750   = +9,250+5,000+500+15,000 = +500+13,000+10,000+7,500-1,250 =                   29,750

                h) Company paid $850 wages expense.
                    1. Ask: What Accounts are involved? Cash and Expenses (Wages
                       Expense).
                    2. Ask: What are the Classifications of these accounts? Cash is an
                       asset and wages expense is a part of owner’s equity. The wages
                       expense definitely does not provide a future benefit as employees are
                       paid after they provide work for the business.
                    3. Ask: Are the accounts Increased or Decreased? Both cash and
                       owner’s equity where the expense is classified under are being
                       decreased by $850. Therefore enter a -850 under the Cash column
                       and the Expenses column on the line with the letter (h).The expenses
                       themselves are increasing as now the total expenses would be 2,100.
                       This transaction can be shown as follows showing the dual effect:
                             A       =     L     +    OE
                                -                         -
                    4. Check that the accounting equation is in balance as follows:
Total               Assets              =               Equities                      Total
28,900   = +8,400+5,000+500+15,000 = +500+13,000+10,000+7,500-2,100 = 28,900
               i) Company received a bill of $275 for utilities but will not pay the bill
                  until the following month.



                                             9
                      1. Ask: What Accounts are involved? Accounts Payable and
                         Expenses (Utilities Expense). Refer to the explanation under the
                         realization principle above that states that revenues are recognized
                         when they are earned and likewise expenses will be recognized when
                         they are incurred even though cash may be paid at a different time.
                         Therefore, this transaction needs to be recorded as soon as it is
                         received so that the expense is recognized even if the expense will be
                         paid before the month is over. THIS IS A TRANSACTION THAT
                         IS HEAVILY MISSED. What many students have done in the
                         past is just ignore this transaction when the bill is received but
                         then accounting principles are being VIOLATED as expenses
                         need to be recognized and therefore recorded when they are
                         incurred.
                      2. Ask: What are the Classifications of these accounts? Accounts
                         Payable is a liability and Utilities Expense is an expense which is part
                         of owner’s equity.
                      3. Ask: Are the accounts Increased or Decreased? This transaction is
                         an example of a transaction that all the accounts occur on the same
                         side of the accounting equation. When this happens, one account or
                         classification must increase and the other must decrease to keep the
                         equation in balance. With this transaction, the Accounts Payable
                         account in increased as the business has additional debt that is owed
                         with this utilities bill. So the liabilities classification in increased.
                         But the owner’s equity classification will decrease because expenses
                         decrease owner’s equity. Therefore, the accounting equation is still in
                         balance as there is an increase and a decrease on the SAME side of
                         the accounting equation. This transaction can be shown as follows
                         showing the dual effect and note that the total assets and total
                         equities stay the same as after the transaction (h) as there was just
                         an increase and a decrease on the same side so the overall totals
                         stay the same.:
                                A      =       L      +     OE
                                             +             -
                    4. Check that the accounting equation is in balance as follows:
Total               Assets               =                  Equities                    Total
28,900   = +8,400+5,000+500+15,000 = +775+13,000+10,000+7,500-2,375 = 28,900
                    5. To see transactions that just affect the ASSET side of the accounting
                       equation, refer to Transaction (C ) on the bottom of page 7 and the
                       top of page 8 and Transaction (K) on page 11 of the textbook.
                       Transaction (C ) is a purchase of supplies for cash and therefore cash
                       is decreased and supplies are increased. This could also happen if
                       equipment is purchased with cash. Transaction (K) is the transaction
                       when a customer makes a payment on their account. Note on page 11
                       that cash is increased and accounts receivable in decreased. This is a
                       transaction that is often missed as the transaction reads “Received
                       $3000 cash as partial payment for services performed on account.


                                             10
                          The key words here are “on account” which is the clue that it needs
                          to reduce an accounts receivable. A common incorrect entry is to
                          increase the revenues. But that will double count the revenues account
                          and therefore you will be paying double taxes on the same
                          transaction. Also the customer will not be happy as they will be
                          billed again as if they had not made a payment on their account. Both
                          of these transactions are what is called a shift in assets, that is, the
                          individual assets did change but the total dollar value of the assets
                          remains the same. These shift in assets transactions can be shown as
                          follows showing the dual effect:
                                 A      =      L     +     OE
                               -,+
                                or
                               +,-

               j) Owner takes a draw of $1,000.
                   1. Ask: What Accounts are involved? Cash and Owner’s Capital
                       (Owner’s Drawing account). Unlike employees, the owner of the
                       business does not receive a salary as a sole proprietorship is not a
                       separate legal entity. The owner then will withdraw cash or other
                       assets from the business but it cannot be an expense. An owner’s
                       withdrawal—the removal of business assets for personal use—has
                       the dual effect of decreasing both the asset taken and the value of the
                       business and is show under the owner’s Capital account as a
                       decrease to that account. That way it still shows a decrease to the
                       owner’s equity but under the capital section, NOT the expense
                       section. The owner takes assets out of the business and does not put
                       anything back in its place so it reduces owner’s equity.
                   2. Ask: What are the Classifications of these accounts? Cash is an
                       asset and owner’s capital (Drawing) is a part of the owner’s equity.
                   3. Ask: Are the accounts Increased or Decreased? Both cash and
                       owner’s equity are being decreased. Therefore enter a -1,000 under
                       the Cash column and the Owner’s Capital column on the line with
                       the letter (j) This transaction can be shown as follows showing the
                       dual effect:
                              A       =      L      +    OE
                               -                          -
                   4. Check that the accounting equation is in balance as follows:
Total               Assets                =                 Equities                      Total
27,900   = +7,400+5,000+500+15,000 = +775+13,000+9,000+7,500-2,375 = 27,900
                   Once all the transactions are entered for a period, the individual accounts
                   are totaled and then the total assets are added together and the total
                   equities are added together like show under number 4 above to prove that
                   the accounting equation is in balance.



                                             11
Summary of transactions example:
                          ASSETS                           =             LIABILITIES         +             OWNER'S EQUITY

              Accounts                                              Accounts        Notes
Cash     +   Receivable     +   Supplies   +   Equipment   =        Payable    +   Payable   +   Capital    + Revenues   - Expenses

10,000   +                  +              +               =                   +             +   10,000

         +                  +      500     +               =          500      +             +

-1,000   +                  +              +               =                   +             +                             -1,000

-2,000   +                  +              +    15,000     =                   +   13,000    +

2,500    +                  +              +               =                   +             +                2,500

         +     5,000        +              +               =                   +             +                5,000

 -250    +                  +              +               =                   +             +                              -250

 -850    +                  +              +               =                   +             +                              -850

         +                  +              +               =          275      +             +                              -275

-1,000   +                  +              +               =                   +             +   -1,000

7,400    +     5,000        +      500     +    15,000     =          775      +   13,000    +   9,000        7,500        -2,375

               Total assets     27,900                          Total equities     27,900


                                   Follow through the transactions in the chapter on a transaction
                                   spreadsheet like shown above. I have found that doing this helps to
                                   cement the concepts before you do the homework problems
                                   demonstrating your understanding of the concepts. In my teaching
                                   career with accounting, this concept is very evident: I HEAR AND I
                                   FORGET. I SEE AND I REMEMBER. I DO AND I UNDERSTAND.
                                   I have found that it does take the actual act of completing the
                                   problems and the homework to get a good understanding of the
                                   accounting process. Note at the bottom of the summary on page 19 of
                                   the textbook showing the balances in the accounts, that EACH
                                   COLUMN TOTAL IS DOUBLE-RULED (DOUBLE-
                                   UNDERLINED). This is a common accounting practice to always
                                   double-underlined totals to show the reader that this number
                                   represents a total.

III. Financial Statements. Once the accounting equation report with the transactions is
completed and balanced, then the financial statements can be prepared. The financial statements
must be prepared in a particular order as numbers from one statement are needed for the next
statement: First, the Income Statement is prepared. As shown on the handout, page 3, the numbers
for the income statement come from the Revenues and Expenses columns of the accounting
equation list of transactions. Second, the Statement of Owner’s Equity is prepared which uses the
net income or net loss figure from the Income Statement as well as the numbers in the Capital
column of the accounting equation list of transactions. Third, the Balance Sheet is prepared which
uses the balances of all the assets and liability accounts as well as the final number which is the
owner’s ending capital balance from the Statement of Owner’s Equity. PLEASE MAKE A NOTE
THAT SINCE THE FINANCIAL STATEMENTS ARE THE END PRODUCTS OF THE


                                                               12
ACCOUNTING PROCESS which are prepared for users of the financials statements, YOU
DO NOT WANT TO HAVE ANY ABBREVIATIONS ON THESE REPORTS. Also the
proper CURRENCY FORMAT should be used which means the dollar sign will be used at the
top of a column and in the totals (see textbook examples). Refer to illustration below that shows
the Relationship of Owner’s Equity Accounts and which accounts are entered in to the different
financial statements:
                         Assets                            =    Liabilities    +                  Owner's Equity
            Accounts                                                Accounts         J. Ashley,
Cash    +
            Receivable
                           +   Supplies   +   Equipment    =         Payable
                                                                               +
                                                                                      Capital
                                                                                                    +    Revenue   _   Expenses




                                                                                                          Income Statement




                                                                                         Statement of Owner's Equity




                                                     Balance Sheet




                     RELATIONSHIP OF OWNER'S EQUITY ACCOUNTS

                                              BALANCE SHEET



       Assets                     =                       Liabilities                   +                Owner's
                                                                                                          Equity




                                                                                                        Capital
                                                                                                        Account




       +                                  -
    Investments
                                      Drawing                             Revenue                            Expense
 (recorded directly                                                                                 -
                                      Account                             Accounts                           Accounts
in capital account)

                                                                                      SHOWN ON
       SHOWN ON STATEMENT OF                                                            INCOME
          OWNER'S EQUITY                                                              STATEMENT



                                                               13
A. The income statement—a summary of a businesses revenue and expenses for a
specific period of time, such as a month, a quarter, or a year.
        1. Identify the components of the income statement. The format of the income
           statement is revenue minus expenses equals net income (or net loss).
        2. Describe the heading. Heading information tells who, what, and when.
           a. Who: answers the question—name of the firm not the name of the
                owner. For example a company could be Gary Parker, CPA. Professionals
                use their name in the name of the company along with their title. But on
                the financial statements when referring to the owner’s capital, it is just
                the name of the owner without the title so it would just be Gary Parker.
           b. What: answers the question—name of the report and would be Income
                Statement for this report.
           c. When: answers the question—dealing with the date or the accounting
                period just ended. The Income Statement is the accounting period just
                ended.
        3. Investments and withdrawals are not included. Only revenues and expenses
           appear on the income statement. Note the first the category of “Revenue:” is
           shown and then the revenue account(s) are listed. Then the category of
           “Expenses:” is listed and then the individual expense accounts are listed. Note
           that there is not a line between the revenues and expenses but as soon as the
           revenues are listed, the next line is the word, “Expenses:”
        4. From examples in the textbook: Note how the INDENTS are done on this
           statement:
           a. The words Revenues, Expenses, and Net income are next to the margin
                of the statement.
           b. The list of revenues and expenses are indented from the heading.
           c. The words, “Total expenses,” are indented from the final expense
                account.
        5. Revenues (if more than one) and expenses are listed IN ORDER OF SIZE—
           LARGEST TO SMALLEST. This is so that the users of the financial
           statements will see these in order of magnitude so they know which accounts
           are producing the largest revenues (if more than one) and which are the
           largest expenses in the operations of the business. Again the first column will
           list the amounts if there is more than one of a category and the second column
           shows the total of the category.
        6. NOTE FROM THE EXAMPLES THAT ONLY THE “FIRST” WORD ON
           A LINE IS CAPITALIZED unless the word is a proper noun like the name
           of a person or a month in the year. An account name is not a proper noun so
           the owner’s capital should not be capitalized but the owner’s name would be
           capitalized. Also earnings for a corporation in NOT capitalized.
        7. NET INCOME = REVENUES – EXPENSES. If the dollar value of the
           revenues is greater than the dollar value of the expenses, then the company
           has a “Net income,” and those words are written on the line after “Total
           expenses” without skipping any lines. If the expenses are greater than the
           revenues, then the company has a “Net Loss,” and those words are written
           on the line after “Total expenses” without skipping any lines. Also the dollar


                                        14
          amount of the “Net loss” will be shown in parenthesis as is a negative
          number.
       8. NOTE the NET INCOME or NET LOSS FIGURE (AMOUNT) is
          DOUBLE-UNDERLINED as that is the final total of the statement.

B. The statement of owner’s equity—a summary of the changes that have
occurred in owner’s equity during a period of time, such as a month, a quarter, or a
year for a sole-proprietorship (Statement of Retained Earnings for a corportation).
       1. Identify the components of the statement of owner’s equity.
           a. Owner’s capital at the beginning of the period.
           b. Any new owner investments into the business.
           c. The net income or net loss figure from the Income Statement. From
               textbook examples, note the net income from the Income Statement is
               inserted into the Statement of Owner’s Equity showing why the Income
               Statement must be prepared before the Statement of Owner’s Equity.
           d. Owner’s withdrawals are deducted from the net income or the net loss
               for the period as shows the owner is withdrawal some of the earnings.
               But even if the business has a net loss, the owner may have taken
               drawings as it takes assets to be able to withdraw—not net income.
           e. The last component is the total owner’s capital at the end of the period.
       2. The statement of owner’s equity has the same type of heading as the income
           statement.
           a. The first line shows the Who: Name of the company.
           b. The second line shows the What: Name of the financial statement.
           c. The third line shows the When: Period of time the statement covers.
       3. NOTE FROM THE EXAMPLES THAT ONLY THE “FIRST” WORD ON
           A LINE IS CAPITALIZED unless the word is a proper noun like the name
           of a person or a month in the year. An account name is not a proper noun so
           the owner’s capital should not be capitalized but the owner’s name would be
           capitalized.
       4. The FIRST LINE of the statement shows the owner’s name (not the name of
           the company so do not include the owner’s title) with the FULL DATE at
           the BEGINNING of the period (month, day, and year is optional in this
           textbook). The LAST LINE of the statement shows the owner’s name (not
           the name of the company so do not include the owner’s title) with the FULL
           DATE at the END of the period (month, day, and year is optional in this
           textbook).
       5. Identify the FORMULA for ending capital:
           a. The capital at the beginning of the period. If this is the company’s first
               month of operation, then the amount would be the owner’s initial
               investment. This amount goes into the second column.
           b. In the first column is the net income or net loss amount.
           c. – withdrawals for the period (listed in the first column),
           d. = a subtotal that is not labeled in the textbook example.
           e. The capital at the beginning of the period is added to an increase in
               capital for the capital at the end of the period. Alternatively, a decrease


                                        15
            in capital is subtracted from the capital at the beginning of the period to
            arrive at the amount of capital at the end of the period.
       6. NOTE the ENDING OWNER’S CAPITAL AMOUNT is DOUBLE-
          UNDERLINED as this is the final total of the statement.

C. The balance sheet—a listing of a firm’s assets, liabilities, and owner’s equity at a
specific point in time
           1. Identify the components of the balance sheet.
                     a) The balance sheet lists the assets IN ORDER OF LIQUIDITY
                        (how fast an asset will be turned into cash—that is why cash is
                        listed first as that asset is already cash). After cash is accounts
                        receivable as that amount should be collect in a short period of
                        time in the form of cash from the company’s customers. Next
                        are the prepaid expenses such as supplies, prepaid rent, prepaid
                        advertising, prepaid insurance, etc. which will be used by the
                        company usually within one year or less. The last items would
                        the long-term assets such as equipment that will be kept and
                        used by the business usually longer than a year.
                     b) Next the balance sheet lists the liabilities of the company. There is
                        not a set order for the liabilities. Some companies always list
                        accounts payable first and then notes payable as that is usually the
                        order in which they will be paid. Other companies will list the
                        liabilities according to the legal liability to pay them so they would
                        list notes payable before accounts payable.
                     c) Finally the balance sheet shows the owner’s equity which would
                        just be the owner’s capital amount at the end of the period that
                        is calculated on the statement of owner’s equity and brought
                        down into the balance sheet. NOTE that the owner’s capital
                        amount does not show a date next to it as is done on the
                        statement of owner’s equity because the date that is on the
                        heading of the balance sheet is giving the amount in accounts as
                        of the last day of the period so the date does not need to be
                        shown again in that section of the balance sheet.
           2. The Balance Sheet is a detailed version of the accounting equation.
                     a) The first total of the balance sheet reflects the left side of the
                        accounting equation (total assets) and since that is a total, the
                        amount is DOUBLE-UNDERLINED.
                     b) The second total of the balance sheet express the right side of
                        the accounting equation (total equities) which is labeled the two
                        sections of the equities which is “Total liabilities and owner’s
                        equity” and this amount is DOUBLE-UNDERLINED
                        (REMEMBER that you do not abbreviate on financial
                        statements so be sure and spell out the word “and”).
           3. Refer to the heading of the Balance Sheet:.
                     a) The first line shows the Who: Name of the company.




                                          16
                b) The second line shows the What: Name of the financial
                    statement.
                c) The third line shows the When: NOTE THE DIFFERENCE
                    here with the Balance Sheet than what was on the other two
                    statements. Since the balance sheet is showing the “balances”
                    (as the name of the financial statement implies), of the accounts
                    on the last day of the accounting period, it only shows a
                    SINGLE DATE IN TIME. A good way to think of this is that
                    since it is showing balances, it cannot be over a period of time.
                    Take cash, for example, where the balance in that account
                    changes on a constant basis from day-to-day. So the number
                    that shows on the balance sheet is the balance in the cash
                    account at the end of the day on the last day of the accounting
                    period.
       4. This sequence that must be followed in preparing the statements
          illustrated:
                a) The income statement must be prepared first to determine the
                    net income figure which is entered into the statement of owner’s
                    equity.
                b) The statement of owner’s equity must be prepared next to
                    determine the owner’s capital amount at the end of the period.
                c) The balance sheet is prepared last as the ending owner’s capital
                    amount that is calculated in the statement of owner’s equity is
                    needed so that the balance sheet will BALANCE. This is a part
                    that makes accounting an exciting process when you come to the
                    end of the balance sheet and IT BALANCES!!!! HURRAH!!!!!

A statement of cash flows summarizes information about the cash inflows (receipts)
and outflows (payments) for a specific period of time. The statement of cash flows
reports (1) the cash effects of a company’s operations during a period, (2) it s investing
transactions, (3) its financing transactions, (4) the net increase or decrease in cash during
the period, and (5) the cash amount at the end of the period. CHAPTER 14 OF THE
TEXTBOOK JUST COVERS THE STATEMENT OF CASH FLOWS.
THEREFORE, THE PREPARATION TECHNIQUES ARE NOT DISCUSSED IN
THIS CHAPTER.




                                       17

								
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