chapter 1-4

RECORDING BUSINESS EVENTS UNDER AN ACCOUNTING EQUATION

Learning Objective 1-4

  • Show how business events affect the accounting equation.

Accounting Records and Accounts

  • Detailed information about the accounting equation is maintained in records commonly called accounts.
    • For example, information regarding assets may be organized in separate accounts:
    • Cash
    • Equipment
    • Buildings
    • Land
  • The types and number of accounts used depend on the information needs of stakeholders.
    • Businesses can provide very detailed or highly summarized information.
    • More detailed information requires a greater number of accounts.
  • Accounts can be likened to students' notebooks:
    • Some students keep detailed notes in separate notebooks for each class.
    • Others summarize key points in a single notebook.
  • Similarly, businesses may have a varying number of accounts.

Diversity in Account Naming

  • The terms used for accounts can vary:
    • Employee pay may be referred to as salaries, wages, or commissions.
  • Accounting as a language:
    • The same word may have different meanings in different contexts.
    • Different terms may describe the same concept.
    • Familiarity will increase with study and practice in accounting.

Accounting Periods

  • Companies report on business activity over time, referred to as an accounting period.
    • The typical accounting period for a comprehensive set of financial statements is one year.
    • The Securities and Exchange Commission (SEC) requires public companies to issue abbreviated quarterly reports.

Accounting Events

  • Companies experience numerous accounting events during an accounting period.
    • Accounting event: An economic occurrence that changes total assets, liabilities, or stockholders' equity.
    • Transaction: A specific type of event involving the transfer of value between two parties.
    • Examples include:
      • Acquiring assets from owners.
      • Borrowing money from creditors.
      • Purchasing or selling goods and services.

Asset Source Transactions

  • Businesses obtain assets from three primary sources:
    1. Owners (stockholders)
    2. Creditors
    3. Profitable operations
  • Asset source transactions: Increase total assets and total claims (liabilities and stockholders' equity).
Event 1: Issuance of Common Stock
  • Rustic Camp Sites (RCS) was formed on January 1, Year 1, acquiring $120,000 cash from issuing common stock.
    • Received cash and issued stock certificates to investors as receipts.
    • This transaction:
    • Increases assets (cash) by $120,000.
    • Increases stockholders' equity (common stock) by $120,000.
Accounting Equation after Event 1
  • Equation Structure:
    • Assets = Liabilities + Stockholders' Equity
    • Breakdown:
    • Cash: $120,000
    • Land: N/A
    • Notes Payable: N/A
    • Common Stock: $120,000
    • Retained Earnings: N/A
Event 2: Borrowing from a Creditor
  • RCS borrows $400,000 cash from a creditor.
    • This transaction involves:
    • Increasing assets (cash) by $400,000.
    • Increasing liabilities (notes payable) by $400,000.
Accounting Equation after Event 2
  • Breakdown:
    • Cash: $400,000 (new total of $520,000)
    • Land: N/A
    • Notes Payable: $400,000 (new total)
    • Common Stock: $120,000
    • Retained Earnings: N/A

Asset Exchange Transactions

  • Businesses often trade one asset for another, leading to changes in asset composition without affecting total asset value.
Event 3: Purchase of Land
  • RCS pays $500,000 cash to purchase land.
    • This transaction:
    • Decreases the Cash asset account by $500,000.
    • Increases the Land asset account by $500,000.
Accounting Equation after Event 3
  • Breakdown:
    • Cash: $520,000 - $500,000 = $20,000
    • Land: $500,000
Event 4: Earning Revenue from Campsite Lease
  • RCS earns $85,000 cash by leasing campsites to customers.
    • Revenue corresponds to an increase in cash assets.
    • This increase is balanced by an increase in stockholders' equity (retained earnings).
Accounting Equation after Event 4
  • Breakdown:
    • Cash: $85,000 (new total)
    • Revenue is not yet in Retained Earnings but is recorded separately.

Asset Use Transactions

  • Businesses may use assets to pay off liabilities, transfer to owners, or generate earnings.
  • Asset use transactions decrease total assets and claims on those assets.
Event 5: Payment for Operating Expenses
  • RCS pays $50,000 cash for operating expenses (salaries, rent, interest).
    • This transaction:
    • Decreases the Cash asset account by $50,000.
    • Decreases stockholders' equity (retained earnings) due to expenses incurred to generate revenue.
Accounting Equation after Event 5
  • Breakdown:
    • Cash: $20,000 - $50,000 = -$30,000 (contextually replaced with balances)
    • Retained Earnings: reduces by $50,000.
Event 6: Payment of Dividends
  • RCS pays $4,000 cash in dividends to its owners.
    • This transaction:
    • Decreases the Cash asset account by $4,000.
    • Decreases stockholders' equity (retained earnings) by $4,000.
Accounting Equation after Event 6
  • Breakdown:
    • Cash: reduced accordingly
    • Retained Earnings: reflects the dividend payment.
Event 7: Appraised Market Value of Land
  • On December 31, Year 1, the land RCS paid $500,000 for has an appraised market value of $525,000.
    • Accountants do not increase the recorded amount in financial records above historical cost.
    • The historical cost concept mandates that assets be recorded at the purchase price, regardless of market value fluctuations.
The Significance of Historical Cost
  • Financial information based on verified historical cost is generally preferred over opinions on current market values as it can be independently verified.
  • Exceptions exist where market value is clearly established (e.g., securities on the New York Stock Exchange must be recorded at market value).

Summary of Transactions

  • The complete collection of a company's accounts is known as the general ledger.
  • A summary of the accounting events and the corresponding general ledger accounts is presented below:
    1. RCS issued common stock, acquiring $120,000 cash from its owners.
    2. RCS borrowed $400,000 cash.
    3. RCS paid $500,000 cash to purchase land.
    4. RCS received $85,000 cash from earning revenue.
    5. RCS paid $50,000 cash for expenses.
    6. RCS paid dividends of $4,000 cash to the owners.
    7. The land that RCS purchased had an appraised market value of $525,000 on December 31, Year 1.

General Ledger Accounts Organized under the Accounting Equation

  • The accounting balances organized as follows:
Assets
  • Cash
  • Land
Liabilities
  • Notes Payable
Stockholders' Equity
  • Common Stock
  • Retained Earnings (summary of Revenue, Expenses, and Dividends)
Example Balances
  • Beginning balance in assets: 0
  • Ending balance after all transactions:
    • Cash: $51,000
    • Land: $500,000
    • Notes Payable: $400,000
    • Common Stock: $120,000
    • Retained Earnings: $31,000