Chapter 2 Lecture Notes
This chapter introduces you to the business transaction which is any
financial event that changes the resources of a firm – the accounting
process starts with the analysis of business transactions. The first step of
the recording process is determining whether a financial event such as a
purchase or sale is a business transaction; most business transactions have
at least two effects. When a business transaction occurs it is analyzed to
identify how it affects the equation property equals financial interest. The
first step is to describe the financial event (describe the property, identify
the owner of the property, and determine the amount of increase or
decrease). The second step is to make sure the equation remains in balance.
An owner’s financial interest in the business is called equity or capital.
When a business purchases something such as equipment and pays cash for it
the equation remains in balance: the amount of equipment they own increases
and the amount of cash they have decreases by that amount (see the bottom
of page 25 for an example). When items are purchased on credit there is
what is known as an accounts payable (an amount a business must pay in the
future). When purchasing equipment on credit the property side of the
equation will increase as well as the financial interest side of the equation
and the equation remains in balance.
In accounting we deal with something called the fundamental accounting
equation, which is how accountants show the relationship between assets,
liabilities, and owner’s equity in an equation.
The equation is: Assets = Liabilities + Owner’s Equity
Assets are the property that a business owns (such as cash and equipment in
the previous examples). Liabilities are debts or obligations of the business
(such as the accounts payable in the previous example). The owner’s
financial interest is called Owner’s Equity.
When running a business you earn revenue and incur expenses. Revenue is
the inflow of assets as a result of the sale of goods or services and
expenses are the costs associated with earning revenue. An expense is
something that was used up and can create a liability if not paid; however,
expenses are not the same as liabilities. If I use two yards of bark to
landscape a yard I will have created a “bark” expense - if I pay cash for the
bark the transaction is complete and there is no liability; if I purchase the
bark on credit then I will have an account payable for the bark and there will
be a liability associated with that expense.
When you sell something for cash it increases the asset, cash, and increases
the revenue (which falls under the owner’s equity part of the equation). If
you sell something on credit you have an asset known as accounts receivable
– we record the transaction even though no payment has been made because
we have earned it (there is an increase in the asset, account receivable and
an increase in revenue). When collecting on an account receivable, however,
you do not record revenue because it has already been recorded and should
not be recorded twice (this will be discussed in greater detail in chapter 5).
Just as revenues increase owner’s equity, expenses decrease it; for example,
if you pay an expense - your asset, cash, decreases and the owner’s equity
decreases – the equation remains in balance. If an owner withdraws money
from the business this is for their personal use and therefore not an
expense, although it does decrease owner’s equity (as the remaining balance
is less).
Revenues and expenses are detailed on the income statement, the first in a
series of three reports that provide financial information about the business.
This reports whether the business had a “net income” or a “net loss”. The
heading includes the “who”, the “what” (income statement), and the “when”
(for the income statement this is a period of time covered).
The statement of owner’s equity is the next report in the series – this
reports the changes that occurred in the owner’s financial interest during
the period. It includes investments, net income/loss (taken from the income
statement), and any withdrawals the owner has made. This statement also
has a three line heading with the “who”, “what” (statement of owner’s equity),
and “when” (for the period of time covered).
The final report in this series is the balance sheet which contains
information about assets, liabilities, and the balance in the owner’s equity
account (taken from the statement of owner’s equity). This points out the
equality of the fundamental accounting equation (Assets = Liabilities +
Owner’s Equity). This statement also has a three line heading (who, what,
when); however, the “when” is different because the balance sheet provides
a snapshot of how the company is doing at a given point in time – therefore it
has a single date for the when instead of “for the period ending …” as on the
other two statements.
Figure 2.6 on page 39 shows the three statements and how they coordinate
with each other.