Module 2

Accounting and the Business Environment

(part 2)

 

Objective 4: Use the accounting equation to analyze business transactions
  1. A business transaction is an event that affects the financial position of a business and may be reliably recorded.
  2. The accounting equation must balance after each transaction is recorded.
  3. The following transactions and their effects on the accounting equation are discussed in the chapter and illustrated in Exhibit 1-6.
    1. Owner investment to begin the business—increases the asset, Cash, and increases the owner’s equity account, Capital.
    2. Cash purchase of land—increases the asset, Land, and decreases the asset, Cash.
    3. Purchase of office supplies on credit—increases the asset, Office Supplies, and increases the liability, Accounts Payable.
    4. Providing services for cash—increases the asset, Cash, and increases revenue (which is an owner’s equity account).
    5. Providing services on account—increases the asset, Accounts Receivable, and increases revenue, an owner’s equity account. Revenue is earned and recorded when the business performs the service, not when cash is received.
    6. Payment of expenses—decreases the asset, Cash, and increases expenses, which decreases owner’s equity.
    7. Payment on account—decreases the asset, Cash, and decreases the liability, Accounts Payable.
    8. A personal transaction has no effect on the accounting equation of a business and should not be recorded.
    9. Collection on account—increases the asset, Cash, and decreases another asset, Accounts Receivable.
    10. Cash sale of land at cost—increases the asset, Cash, and decreases another asset, Land.
    11. Withdrawal of cash by the owner—decreases the asset, Cash, and increases the owner’s equity account, Withdrawals, which decreases owner’s equity.

Objective 5: Prepare and use the financial statements
  1. The four primary financial statements are the income statement, statement of owner’s equity, balance sheet, and statement of cash flows.
    1. The income statement (statement of earnings or statement of operations) lists revenues and expenses and shows net income or net loss—revenues minus expenses.
    2. The statement of owner’s equity shows the changes that take place in owner’s equity during the period from net income or net loss, withdrawals, and owner’s investment.
    3. The balance sheet lists all assets, liabilities, and owner’s equity as of a specific date.
    4. The statement of cash flows reports the cash receipts and cash payments during a period as well as the net cash inflow or outflow.
  1. Each financial statement has a heading that includes the name of the business, the name of the company, and the date or time period covered by the statement.

1. The date of the balance sheet is the last day of the accounting period.

2. The statement of owner’s equity, income statement, and statement of cash flows cover an entire accounting period.

Objective 6: Evaluate the performance of a business

  1. All of the financial statements are interrelated. (Exhibit 1-7 illustrates all four financial statements. Arrows link information from one statement to the next.)

B. The financial statements must be prepared in the following order: income statement, statement of owner’s equity, balance sheet, and statement of cash flows.
    1. Net income (or net loss) is reported on the income statement.

a. Report a net income if revenues exceed expenses. Report a net loss if expenses exceed revenues.
    1. Expenses are listed in decreasing order of amount.
    2. The formula for net income is:

Revenues

= Net income or Net loss
    1. The statement of owner’s equity appears in the following format:

      2. Owner’s capital, beginning of the period

      Add: Investments by owner

      Net income (from income statement) or deduct net loss

      Less: Withdrawals by owner

      Owner’s capital, end of period

    2. The balance sheet reports assets, liabilities, and owner’s equity as of the end of the period.
    1. The balance sheet must balance. The sum of the assets must equal the sum of the liabilities plus owner’s equity.
    2. The owner’s capital account balance is taken directly from the statement of owner’s equity.
    1. The statement of cash flows reports cash flows from three types of activities:
    1. Cash flows from operating activities are cash receipts from revenues and cash payment of expenses.
    2. Cash flows from investing activities are cash flows from the purchase and sale of assets that the business expects to use for a long time.
    3. Cash flows from financing activities are receipts and payments from people who finance the business—investors and creditors.

 

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