C5 THE Effects OF Transactions ON THE Accounting Equation PDF

Preview

Summary

Different courses to help you nail marketing...

Description

THE EFFECTS OF TRANSACTIONS ON THE ACCOUNTING EQUATION In accounting terms, a transaction is defined as an event which affects the financial position of a business. It involves the exchange of money for money’s worth of goods or services between two parties. Buying and selling goods and receiving or paying money are transactions. There are two main types of transaction:  cash – where money is received in exchange for goods or services  credit – where goods or services are supplied or received on agreement that payment will be made at a later date. The transaction is the basic operating unit of the business. Cash is used to purchase goods, these goods are then sold, and the cash received for them is used to purchase more goods which, in turn, are sold. This cycle of cash  goods  cash is called the operating cycle. The accounting equation stands for the static view of the balance sheet. As such, the balance sheet represents the financial condition of an enterprise at a noted date (the end of the financial year, usually corresponding to the end of the calendar year). Yet, each passing transaction or event brings about a change in the overall financial condition of the enterprise. Business activities will impact various asset, liability, and/or equity items, but they will not disturb the equality of the accounting equation. The effect of any transaction on the accounting equation may be indicated by increasing or decreasing a specific asset, liability or owner’s equity element, without upsetting the basic equality of the overall balance sheet. To illustrate, assume the following transactions took place during January, 200X, for Mr. Ady, a dentist. The effect of these transactions on the accounting equation can be analyzed as follows: Transaction (a): Owner invested $30 000 cash in the business. Effect on Accounting Equation. An increase in an asset offset by increase in owner’s equity. Analysis. Mr. Ady opened a bank account for his business with a deposit of $30 000. This transaction increased the asset Cash and in the same time owner’s equity – Mr. A, Capital – was increased by the same amount. The equation for the business would appear as follows: Assets = Cash (a) +30 000

Liabilities =

+

Owner’s Equity Mr. A, Capital + 30 000

Total Assets: $30 000 = Total Liabilities + Owner’s Equity: $30 000

Transaction (b): Purchased office equipment on account, $2 500. Effect on Accounting Equation. An increase in an asset offset by increase in liability. Analysis. This transaction caused the asset Office equipment to increase, and the liability Accounts Payable to increase by the same amount. The accounting equation is: Assets + Office Equip. Bal. $30 000 (b) +2 500 Bal. $30 000 + $2 500 Cash

= =

Liabilities Accounts Payable

=

+2 500 $2 500

+

Owner’s Equity Mr. A, Capital

+

$30 000 1

Total Assets: $32 500 = Total Liabilities + Owner’s Equity: $32 500 Transaction (c): Purchased office supplies for cash, $350. Effect on Accounting Equation. An increase in one asset offset by a decrease in another asset. Analysis. This transaction caused a $350 decrease in the asset Cash. The asset Office Supplies increased by $350. The effect on the equation is as follows: Assets = Liabilities + Office + Office = Accounts Supp. Equip Payable Bal. $30 000 $2 500 (c) -350 +350 +2 500 Bal. $29 650 + $350 + $2 500 = $2 500

+

Owner’s Equity Mr. A, Capital

Cash

$30 000 $30 000

+

Total Assets :$32 500 = Total Liabilities + Owner’s Equity: $32 500

Transaction (d): Paid amount owed to a creditor, $500. Effect on Accounting Equation. A decrease in an asset offset by a decrease in a liability. Analysis. This payment caused both the asset Cash and the liability Accounts Payable to decrease by $500. The effect in the equation is as follows: Assets = Liabilities + Office + Office = Accounts Supp. Equip Payable Bal. $29 650 $350 $2 500 $2 500 (d) -500 -500 Bal. $29 150 + $350 + $2 500 = $2 000

+

Owner’s Equity Mr. A, Capital

Cash

$30 000 $30 000

+

Total Assets :$32 000 = Total Liabilities + Owner’s Equity: $32 000

Transaction (e): Purchased office supplies on account, $400. Effect on Accounting Equation. An increase in an asset offset by an increase in a liability. Analysis. This transaction caused the asset Office Supplies in increase by $400 and increased the liability Accounts Payable by the same amount. The effect of this transaction on the equation is as follows:

Assets = Liabilities + Office + Office = Accounts Supp. Equip Payable Bal. $29 150 $350 $2 500 $2 000 (e) +400 +400 Bal. $29 150 + $750 + $2 500 = $2 400

+

Owner’s Equity Mr. A, Capital

Cash

+

$30 000 $30 000

Total Assets : $32 400 = Total Liabilities + Owner’s Equity: $32 400

2

Problem. Mr. R. Stevenson wishes to go into business for himself. He is experienced in the decorating field and purchases an established business, Metro Interiors (a small furnishing store), for $50 000, which includes trading stock valued at $30 000. When he commences trading on 1 August 2013, his accounting equation is shown as:

Transaction 1

Cash

Assets

=

Liabilities

$20 000

= Capital

+

Owner’ Equity $50 000

Inventory $30 000 $50 000

$50 000

Assets ($50 000) = Liabilities + Owner’s Equity ($50 000) Transaction2 On 3 August 2013, Metro Interiors purchases $7 000 of office furniture on credit from Designer Offices. The effect of this transaction on the accounting equation is: Assets = Liabilities + Cash

$20 000

Inventory

$30 000

Office Furniture

$7 000

Owner’ Equity

= Capital Sundry CreditorDesigner Offices

$7 000 $7 000

$57 000

+

$50 000 $57 000

Assets ($57 000) = Liabilities ($7 000) + Owner’s Equity ($50 000) Metro Interiors has now acquired another asset, office furniture (something it owns), but at the same time it has acquired a liability, a sundry creditor (a person or business to whom it owes money). The two accounts involved in this transaction are the asset account Office Furniture (which has increased) and the liability account Sundry Creditor – Designer Offices (which has also increased). Transaction 3 On 5 August 2013, Metro Interiors purchases a computer for $5000 cash. This transaction affects the accounting equation in the following way: Assets = Liabilities + Owner’ Equity Cash

$15 000

Inventory

$30 000

= Capital Sundry CreditorDesigner Offices

$50 000

$7 000

3

Office Furniture Office Equipment

$7 000

+

$50 000

$7 000

$5000 $57 000

$57 000

Assets ($57 000) = Liabilities ($7 000) + Owner’s Equity ($50 000) In this transaction are involved the asset Cash (which has decreased) and another asset Office Equipment (which has increased to reflect the acquisition of the computer). Transaction 4 On 8 August 2013, the owner withdrew $500 cash for personal use. This transaction affected the asset Cash and the Drawing, an owner’s equity account which records amounts of cash (or stock) withdrawn from the business by the owner. Assets

=

Liabilities

Cash

$14 500

= Capital

Inventory

$30 000

Sundry CreditorDesigner Offices

+

$50 000

$7 000

Drawings

(500) $7 000

Office Furniture Office Equipment

Owner’ Equity

+

$49 500

$7 000

$5000 $56 500

$56 500

Assets ($56 500) = Liabilities ($7 000) + Owner’s Equity ($49 500) The withdrawal of $500 cash decreases the asset account Cash and increases the Drawings account. The increase in the Drawings account reduces the amount of owner’s equity in the business, as drawings are always recorded as a deduction from owner’s equity. Withdrawals by the owner may be in the form of cash or goods taken from stock for personal use. These withdrawals cannot be recorded as business expenses as they are to be used for personal expenses. Withdrawals by the owner from a business decrease the owner’s equity in the business. Transaction 5 On 15 August 2013, Metro Interiors purchases shop fittings on credit from Custom Interiors for $6 000, paying a cash deposit of $1 000. Assets

=

Liabilities

Cash

$13 500

= Capital

Inventory

$30 000

+

Owner’ Equity $50 000

Sundry Creditor4

Designer Offices

$7 000

Drawings Office $5000 Equipment Shop Fittings

Sundry CreditorCustom Interiors

$6 000

(500) $5 000 $12 000

+

$61 500

$49 500 $56 500

Assets ($61 500) = Liabilities ($12 000) + Owner’s Equity ($49 500) This transaction involves three accounts – Metro Interiors acquires an asset (Shop Fittings), the asset account Cash has decreased because the business withdrew money ($1 000) to pay a cash deposit and a liability was created in the form of a Sundry Creditor (Custom Interiors) to which Metro Interiors owes $5 000 for shop fittings purchased on credit.

Owner’s Equity and the Capital Account Owner’s equity (or proprietorship, or capital) is the amount that the proprietor originally invested at the commencement of the business. It is the internal equity of the business and is recorded in the general ledger as the Capital account, which, at the end of the reporting period, shows the following details:  the amount of capital which is owed by the business to the proprietor  plus any additional capital invested in the business by the proprietor  less any drawings the proprietor takes from the business (in the form of inventory or other asset, cash or cheques drawn on the business for cash or for the payment of private expenses)  plus any profit the business earns – or less any loss which the business incurs. The accounting equation may be expand now, by including profit and loss: Assets = Liabilities + Owner’s Equity + Profit If Profit = Revenue – Expenses Therefore Assets = Liabilities + Owner’s Equity + Revenue – Expenses Where (a) profit is the excess of revenue over expenses for a given period. (If there is an excess of expenses over revenue for a given period, a loss results.) (b) revenues is the increase in owner’s equity resulting from selling goods or providing services, plus any income received from other sources for a given period. (c) expenses are decreases in owner’s equity arising from the costs of operating the business. In a loss situation, the equation would be stated as: Assets = Liabilities + Owner’s Equity – Loss

Using the expanded accounting equation, let’s continue the analysis for Metro Interiors. 5

Transaction 6 On 16 August 2013, Metro Interiors sells goods on credit, valued at $18 000. The effect of this transaction on the accounting equation is: Assets Cash

= Liabilities +

Owner’ Equity +

Revenue

-

Expenses

$13500 =

Capital

$50 000

Inventory

Office Furniture

$30000

$7 000

Sundry CreditorDesigner Offices $7 000 Office Equipment

$5000

Drawings Shop Fittings

(500)

$6 000

Sundry CreditorCustom Interiors $5000 Sales

$18 000

Accounts Receivabl e

$18000 $79500 = $12 000

+ $49 500 +

$18 000

Assets ($79 500) = Liabilities ($12 000) + Owner’s Equity ($49 500) + Revenue ($18 000) The two accounts affected by this transaction are: - Sales – a revenue account which is increased to record the revenue from credit sales of trading goods. - Accounts Receivable – an asset account which increased to reflect the amount owing to the business by trade debtors. The Sales account is used to record credit sales of trading sock. 6

During the course of the business, inventory is depleted and replenished on a recurring basis as stock is sold and then replaced. Sales of trading stock are recorded in the Sales account as a revenue of the business. The business has also acquired an asset account, Accounts Receivable, in which details of transactions with trade debtors (persons or business to whom Metro Interiors sell trading goods on credit) are recorded. This account is increased to reflect the increase in amounts owing by trade debtors. Transaction 7 On 18 August 2013, Metro Interiors purchases $10 000 of trading goods (also known as trading stock) on credit. The effect of this transaction on the expanded accounting equation is as follows: Assets Cash

Office Furniture

Liabilities +

Owner’ Equity +

Revenue

-

Expenses

$13500 =

Capital Inventory

=

$50 000 $30000

$7 000

7

Sundry CreditorDesigner Offices $7 000 Office Equipment

$5000

Drawings Shop Fittings

(500)

$6 000

Sundry CreditorCustom Interiors $5000 Sales

$18 000

Accounts Receivable

$18000

Purchases

$10 000

Accounts Payable

$10 000 $79500 = $22 000

+ $49 500 +

$18 000

-

$10 000

Assets ($79 500) = Liabilities ($22 000) + Owner’s Equity ($49 500) + Revenue ($18 000) – Expenses ($10 000) The two accounts affected by this transaction are: -

Purchases – an expense account which is increased to record the expense of purchasing trading goods on credit - Accounts Payable – a liability account which is increased to reflect the amount owing to trade creditors. The Purchases account is used to record credit purchases of trading stock. Replacements or additions to trading stock are recorded in the Purchases account as an expense of the business. The business has also required a liability account, Accounts Payable, in which details of transactions with trade creditors (persons or business from which Metro Interiors has purchased trading goods on credit) are recorded. The Accounts Payable account has increased to reflect the amount owing to trade creditors. Transaction 8 Metro Interiors paid wages to employees ($1 000) on 23 August 2013. The effect of this transaction on the accounting equation is:

8

Assets

=

Liabilities +

Owner’ Equity +

Revenue

-

Expenses

9

$12500 =

Cash Capital

$50 000

Inventory

Office Furniture

$30000

$7 000

Sundry CreditorDesigner Offices $7 000 Office Equipment

$5000

Drawings Shop Fittings

(500)

$6 000

Sundry CreditorCustom Interiors $5000 Sales

$18 000

Accounts Receivable

$18000

Purchases

$10 000

Accounts Payable

$10 000

Wages Expense

$1 000 $78500 = $22 000

+ $49 500 +

$18 000

-

$11 000

Assets ($78 500) = Liabilities ($22 000) + Owner’s Equity ($49 500) + Revenue ($18 000) – Expenses ($11 000) The Wages Expense account has increased to reflect the increase in that account and the Cash account has decreased to reflect the amount drawn to meet the wages expense. Transaction 9 On 28 August 2013, Metro Interiors paid an electricity account of $400. 10

The effect of these transaction on the accounting equation is:

Cash

Assets

= Liabilities + Owner’ Equity

$12100

=

Capital Inventory

Office Furniture

+

Revenue

-

Expenses

$50 000 $30000

$7 000

Sundry CreditorDesigner Offices $7 000 Office Equipment

$5000

Drawings Shop Fittings

(500)

$6 000

Sundry CreditorCustom Interiors $5000 Sales Accounts Receivable

$18 000

$18000

Purchases

$10 000

Accounts Payable

$10 000

Wages Expense

$1 000

Electricity

$400 $78100

= $22 000

+ $49 500

+

$18 000

-

$11 400

Assets ($78 100) = Liabilities ($22 000) + Owner’s Equity ($49 500) + Revenue ($18 000) – Expenses ($11 400) 11

The two accounts affected by this transaction are the Cash account which has decreased and the Electricity expense account which has increased. Transaction 10 On 29 August 2013, the owner invests a further $10 000 in the business. This has the following effect on the accounting equation: =

Account

Assets

Cash

$22100 =

Liabilities +

Capital

Owner’ Equity

+

Revenue

-

Expense s

$60 000

Inventory

$30000

Office Furniture

$7 000

Sundry CreditorDesigner Offices

$7 000

Office $5000 Equipment Drawings Shop Fittings

(500) $6 000

Sundry CreditorCustom Interiors

$5000

Sales

$18 000

Accounts $18000 Receivable Purchases Accounts Payable Wages Expense Electricity

$10 000 $10 000 $1 000 $400

$88100 = $22 000

+ $59 500

+

$18 000

-

$11 400

Assets ($88 100) = Liabilities ($22 000) + Owner’s Equity ($59 500) + Revenue ($18 000) – Expenses ($11 400) The investment of $10 000 by the owner increases the Cash account while reflecting an increase in the owner’s equity, Capital. 12

Transaction analysis chart for Metro Interiors Increase Trans. No./

Accounts affected

Type of account

or

Amount

Decrease

$

Summary

Date 2013

Cash

A

Inc.

Aug. 1

Inventory

A

Inc.

OE

Inc.

A

Inc.

7 000

L

Inc.

7 000

A

Inc.

5 000

A

Dec.

5 000

A

Dec.

OE

Dec.

A

Dec.

1 000

Shop Fittings

A

Inc.

6 000

Sundry Creditor –

L

Inc.

5 000

R

Inc.

A

Inc.

E

Inc.

L

Inc.

E

Inc.

1 000

Cash

A

Dec.

1 000

28 Electricity

E

Inc.
<...