Accounting for Business Transactions

Basis of Financial Statements and the Accounting Cycle

• Financial statements start from business transactions and events.

• Process (from transactions to financial statements): identify source documents

• Core equation: Assets = Liabilities + Equity (This is already existing but adding it here to emphasize)

Source Documents

• Identify and describe transactions entering the accounting system.

• Examples: bills from suppliers, sales receipts, checks, purchase orders, payroll records, bank statements.

The Account and Its Analysis

• An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item, serving as the fundamental unit for recording financial transactions.

• Asset accounts: Land, Cash, Buildings, Accounts Receivable, Notes Receivable, Equipment, Prepaid, Supplies.

• Liability accounts: Accounts Payable, Accrued Liabilities, Unearned Revenue.

• Equity accounts: Common Stock, Revenues, Expenses, Dividends.

• Expanded equity: Revenues increase equity; Expenses and Dividends decrease equity.

Ledger and Chart of Accounts

• Ledger: collection of all accounts and their balances.

• Chart of Accounts: list of all accounts with identifying numbers.

Debits and Credits; Double-Entry Accounting

• A T-account shows the effects of transactions.

• Rules (normal balances):

  • Assets: Debit increases, Credit decreases.

  • Liabilities & Equity: Credit increases, Debit decreases.

  • Revenues: Debit decreases, Credit increases.

  • Expenses: Debit increases, Credit decreases.

• Double-entry: every transaction must have total debits = total credits, ensuring the accounting equation remains in balance.

Double-Entry Accounting: Expanded Equation

• Equity components include Owner Capital, Owner Withdrawals, Revenues, and Expenses.

• Expanded form: Resources owned equal claims on resources by creditors and owners. $ext{Assets} = ext{Liabilities} + ext{Owner\'s Equity}$

Journalizing and Posting Transactions

• Four steps: identify transactions and source documents; analyze using the accounting equation; record the journal entry; post to the ledger.

• Transactions are first analyzed using the accounting equation to determine which accounts are affected and whether they increase or decrease, before being recorded in the journal. These recorded transactions ultimately impact the balances presented in the financial statements.

• Journal entries show date, accounts debited and credited, and amounts; posting transfers amounts to the respective ledger accounts.

Processing Transactions (Overview)

• Typical sequence of transaction types: owner investment, purchases (cash or on credit), service revenue (cash or on credit), expenses (cash or on credit), collections, and payments.

• Each transaction affects at least two accounts with equal debits and credits.

Summarizing Transactions in a Ledger

• Ledgers aggregate all entries by account to show running balances.

• Balance reflects the net of increases and decreases.

Trial Balance

• Three steps to prepare: list each account title and its amount from the ledger; sum total debits and total credits; verify that total debits = total credits.

• The trial balance lists all ledger accounts and their balances at a point in time.

• If totals do not balance, identify and correct errors.

Financial Statements

• Financial statements are prepared using the adjusted ledger account balances, summarized from the trial balance, to report on the financial performance and position of a business.

• Four financial statements and their purposes:

  • Income Statement: revenues less expenses over a period.

  • Statement of Retained Earnings: beginning retained earnings + net income
    - Net income: $ext{Net Income} = ext{Revenues} - ext{Expenses}$

  • Retained earnings relationship: beginning RE + net income - dividends = ending RE.

  • Balance Sheet equation (reiterated): $ext{Assets} = ext{Liabilities} + ext{Equity}$

Income Statement Details

• Revenues: include consulting revenue and rental revenue.

• Expenses: include salaries, rent, utilities, and other operating expenses.

• Net income contributes to ending retained earnings on the Statement of Retained Earnings.

Statement of Retained Earnings (Overview)

• Reflects changes in retained earnings over the period due to net income and dividends.

• Ending retained earnings shown on the Balance Sheet.

Balance Sheet (Overview)

• Presents assets, liabilities, and equity at a point in time.

• Total assets equal total liabilities plus total equity.

Presentation Issues

• Dollar signs usage: not used in journals and ledgers; used in financial statements and trial balances.

• In columns, dollar signs are placed beside only the first and last numbers.

Accounts: Quick Reference

• Asset accounts: cash, accounts receivable, notes receivable, inventory, prepaid accounts, supplies, equipment, buildings, land.

• Liability accounts: accounts payable, notes payable, accrued liabilities, unearned revenue.

• Equity accounts: common stock, retained earnings, dividends, revenues, and expenses.

Debt Ratio

• Purpose: Evaluate debt risk and financial condition.

• Formula: $ext{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}$

• Interpretation: Higher ratio indicates greater risk of inability to meet debt obligations.

• Examples (illustrative): Costco around 0.66; Walmart around 0.64 (based on recent data).

Quick Note on Formulas and Concepts

• Asset accounts increase on the debit side; decrease on the credit side.

• Liability and Equity accounts increase on the credit side; decrease on the debit side.

• Revenues increase equity; Expenses and Dividends decrease equity.

• Net income increases retained earnings; dividends reduce retained earnings.

- Trial balance must balance: $ext{TotalDebits}={Total Credits}$