CHAPTER THREE
ANALYZING TRANSACTIONS:
The Accounting Equation
BUSINESS ENTITY
An individual, association, or
organization
That engages in economic activities
And controls specific economic resources
Business entity’s finances kept separate
from those of owner (Business Entity
Concept)
ASSETS
ITEMS OWNED BY A BUSINESS THAT
WILL PROVIDE FUTURE BENEFITS
MUST BE “OWNED”
NOT RENTED
ASSETS
ITEMS OWNED BY A BUSINESS THAT
WILL PROVIDE FUTURE BENEFITS
BUT DOESN’T HAVE
TO BE PAID OFF,
COULD STILL BE MAKING
PAYMENTS ON IT
ASSETS
EXAMPLES:
CASH
MACHINERY
MERCHANDISE
BUILDINGS
FURNITURE
LAND
FIXTURES
ACCOUNTS RECEIVABLE
ACCOUNTS RECEIVABLE
The amount of money owed to the
business
By its customers
As a result of making sales “on account”
or “on credit”
Simply, customers who have promised to
pay sometime in the future
LIABILITIES
PROBABLE FUTURE OUTFLOW OF
ASSETS AS A RESULT OF A PAST
TRANSACTION OR EVENT
IN OTHER WORDS,
DEBTS OR OBLIGATIONS OF THE
BUSINESS THAT CAN BE PAID WITH
CASH, GOODS , OR SERVICES
LIABILITIES
EXAMPLES:
ACCOUNTS PAYABLE
NOTES PAYABLE
ACCOUNTS PAYABLE
Unwritten promise to pay a supplier for
assets purchased or services rendered
Referred to as making a purchase “on
account” or “on credit”
Be careful!! Don’t confuse Accounts
Receivable and Accounts Payable.
Ask yourself, are we waiting to receive? Or
waiting to pay?
NOTES PAYABLE
Formal written promises to pay suppliers
or lenders
Specific sums of money at definite future
times
OWNER’S EQUITY
AMOUNT BY WHICH THE BUSINESS
ASSETS EXCEED THE BUSINESS
LIABILITIES
ALSO CALLED:
NET
WORTH
OR
CAPITAL
EXAMPLE:
If a business has total Assets of $100,000
and total Liabilities of $60,000, what is the
Owner’s Equity?
Once the debts are paid,
the remaining assets belong
to the owner (Owner’s Equity).
EXAMPLE:
If a business has total Assets of $100,000
and total Liabilities of $60,000, what is the
Owner’s Equity?
FORMULA:
ASSETS
LIABILITIES = OWNER’S EQUITY
$100,000
$60,000
=
$40,000
Can also be expressed as:
Assets = Liabilities + Owner’s Equity
BUSINESS ENTITY
CONCEPT
Owner may have business assets and
liabilities and nonbusiness assets and
liabilities
Nonbusiness assets and liabilities are not
included in the entity’s accounting
records
If owner invests money or other assets in
the business, the item is now a business
asset
ACCOUNTING EQUATION
Assets = Liabilities + Owner’s Equity
Left side:
Assets
ACCOUNTING EQUATION
Assets = Liabilities + Owner’s Equity
Right side shows where
the money came from to
buy the assets
BUSINESS TRANSACTION
An economic event that has a direct
impact on the business
Usually requires an exchange with an
outside entity
Must be able to measure this exchange in
dollars
All transactions affect the accounting
equation through specific accounts
ACCOUNT
A separate record used to summarize
changes in each asset, liability, and
owner’s equity of a business
ANALYZING BUSINESS
TRANSACTIONS
THREE QUESTIONS:
QUESTION #1
WHAT HAPPENED?
Make certain you understand the
event that has taken place.
QUESTION #2
WHICH ACCOUNTS ARE
AFFECTED?
•Identify the accounts that are
affected.
•Classify these accounts as assets,
liabilities, or owner’s equity.
QUESTION #3
HOW IS THE ACCOUNTING
EQUATION AFFECTED?
•Determine which accounts have
increased or decreased.
•Make certain that the accounting
equation remains in balance after
the transaction has been entered.
Let’s analyze the effect of
transactions on the accounting
equation for Mary Adams
Consulting
EXAMPLE:
MARY ADAMS, THE OWNER,
INVESTED $25,000 IN THE
BUSINESS
QUESTION #1
What happened?
Mary took $25,000 from her
personal bank account and deposited it
in a new account in the business’ name
QUESTION #2a
Identify accounts that are affected
CASH
M. A.
CAPITAL
QUESTION #2b
Classify these accounts
CASH
ASSET
M. A.
CAPITAL
OWNER’S
EQUITY
QUESTION #3a
Determine whether the accounts
have increased or decreased
CASH
INCREASED
M. A.
CAPITAL
INCREASED
QUESTION #3b
Does accounting equation balance?
ASSETS = LIABILITIES
+ OWNER’S EQUITY
CASH =
+$25,000 =
It Balances!
Assets of $25,000 = Liab. of $0
plus Owner’s Equity of $25,000
M. A.,CAPITAL
+$25,000
EXAMPLE:
PURCHASED OFFICE
SUPPLIES FOR $800 CASH
QUESTIONS #1 & #2
Understand the transaction,
Identify and Classify the affected
accounts
OFFICE
CASH
SUPPLIES
ASSET
ASSET
QUESTION #3a
Increase or Decrease?
OFFICE
SUPPLIES
ASSET
INCREASED
CASH
ASSET
DECREASED
QUESTION #3b
Let’s look at the accounting equation
ASSETS
CASH + OFF. SUPPLIES
-$800
+
+$800
= LIAB.
+
O. E.
=
=
Right hand side
of equation is
not affected
QUESTION #3b
Does transaction balance?
ASSETS
CASH + OFF. SUPPLIES
-$800
+
+$800
= LIAB.
=
=
Yes!
Total Assets stayed the same.
One Asset increased, the other
decreased. No change in
Liabilities or Owner’s Equity
+
O. E.
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
CASH
OFFICE SUPPLIES
$25,000
- $800
$800
BALANCE $24,200
$800
LEFT SIDE OF EQUATION:
CASH
$24,200
SUPPLIES
$ 800
TOTAL ASSETS
$25,000
PROVING ACCOUNTING
EQUATION BALANCES:
LIABILITIES
BALANCE
$0
OWNER’S EQUITY
$25,000
$0
$25,000
RIGHT SIDE OF EQUATION:
$
0
LIABILITIES
$25,000
OWNER’S EQUITY
$25,000
TOTAL LIAB. & O.E.
BALANCE
EXAMPLE
PURCHASED EQUIPMENT ON
ACCOUNT FOR $3,000
QUESTIONS #1 & #2
Understand the transaction,
Identify and Classify the affected
accounts
Mary is buying this copy machine
“on account.” She will be making
payments on it over the next few
years.
NO CASH WAS EXCHANGED TODAY
QUESTIONS #1 & #2
Understand the transaction,
Identify and Classify the affected
accounts
EQUIP.
ACCOUNTS
PAYABLE
LIABILITY
ASSET
QUESTION #3a
Increase or Decrease?
EQUIP.
ASSET
INCREASED
ACCOUNTS
PAYABLE
LIABILITY
INCREASED
QUESTION #3b
Let’s look at the accounting equation:
ASSETS = LIABILITIES
+ OWNER’S EQUITY
EQUIP. = ACCOUNTS
PAYABLE
+ $3,000
+ $3,000 =
This transaction had
no effect on
Owner’s Equity
QUESTION #3b
Does transaction balance?
ASSETS = LIABILITIES
+ OWNER’S EQUITY
EQUIP. = ACCOUNTS
PAYABLE
+ $3,000
+ $3,000 =
It Balances!
Assets increased by $3,000 =
Liab. Increased by $3,000
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
CASH + SUPPLIES + EQUIPMENT
$25,000
- $800
$800
BAL. $24,200
$800
+$3,000
BAL. $24,200
$800
$3,000
SUPPLIES
$ 800
$24,200+$800+$3,000=
$25,000
$28,000 TOTAL ASSETS
PROVING ACCOUNTING
EQUATION BALANCES:
LIABILITIES
ACCTS. PAY.
BAL.
BAL.
+$3,000
$3,000
OWNER’S EQUITY
M. A., CAPITAL
+$25,000
$25,000
$25,000
$3,000 + $25,000 =$28,000
TOTAL LIAB. & O. E.
EXAMPLE
MADE $400 PAYMENT ON EQUIPMENT
QUESTIONS #1 & #2
Understand the transaction,
Identify and Classify the affected
accounts
CASH
ACCOUNTS
PAYABLE
LIABILITY
ASSET
QUESTION #3a
Increase or Decrease?
CASH
ASSET
DECREASED
ACCOUNTS
PAYABLE
LIABILITY
DECREASED
QUESTION #3b
Let’s look at the accounting equation:
ASSETS = LIABILITIES
+ OWNER’S EQUITY
CASH = ACCOUNTS
PAYABLE
- $400
- $400 =
This transaction had
no effect on
Owner’s Equity
QUESTION #3b
Does transaction balance?
ASSETS = LIABILITIES
+ OWNER’S EQUITY
CASH = ACCOUNTS
PAYABLE
- $400
- $400 =
It Balances!
Assets decreased by $400 =
Liab. decreased by $400
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
EQUIPMENT
CASH SUPPLIES
$25,000
- $800
$800
BAL. $24,200
$800
+$3,000
BAL. $24,200
$800
$3,000
-$400
BAL. $23,800SUPPLIES
$3,000
$800
$27,600
PROVING ACCOUNTING
EQUATION BALANCES:
LIABILITIES
ACCTS. PAY.
OWNER’S EQUITY
M. A., CAPITAL
+$25,000
$25,000
BAL.
BAL.
BAL.
+$3,000
$3,000
-$400
$2,600
$25,000
$25,000
$27,600
OWNER’S EQUITY
TRANSACTIONS
FOUR TYPES:
DECREASE:
INCREASE:
EXPENSES
REVENUES
DRAWING
INVESTMENTS
REVENUE
Amount a business charges customers for
products sold or services performed
Recognized when earned (even if cash
has not yet been received)
Increases both Assets (Cash or Accounts
Receivable) and Owner’s Equity
REVENUE
EXAMPLES:
 Delivery Fees
 Consulting Fees
 Rent Revenue (if business rents space to
others)
 Interest Revenue (for interest earned on
bank deposits)
Sales (for sales of merchandise)
EXPENSES
Represent the decrease in assets as a
result of efforts made to produce
revenues
Separate accounts are maintained for
each type of expense
Either decrease assets or increase
liabilities, but ALWAYS decrease
Owner’s Equity
EXPENSES
EXAMPLES:
 Rent
 Supplies Consumed
 Salaries
 Taxes
NET INCOME
REVENUE Greater than EXPENSES = NET INCOME
EXAMPLE: Luke Perkins performed $6,000 of Tax services
(Revenue) this year and incurred expenses of $1,500 for
Rent, $500 for Supplies, and $3,000 in Salaries.
REVENUE
EXPENSES
$6,000
$5,000
= NET INCOME
= $1,000
$1,500 + $500 + $3,000
NET LOSS
EXPENSES Greater than REVENUE = NET LOSS
EXAMPLE: John Atwood performed $8,000 of Delivery
services (Revenue) this year and incurred Expenses of
$3,500 for Rent, $500 for Supplies, $3,000 in Salaries and
$2,500 for Gasoline.
REVENUE
EXPENSES
$8,000
$9,500
= NET LOSS
= ($1,500)
$3,500 + $500 + $3,000 + $2,500
ACCOUNTING PERIOD
CONCEPT
Say that income can be determined for
any period of time (month, quarter, year,
etc.)
Any accounting period of twelve months
is called a FISCAL YEAR
WITHDRAWALS
 The owner taking (withdrawing) cash or
other assets from the business for personal
use
 Reduces Owner’s Equity and Assets
 Also referred to as Drawing
REVENUE EXAMPLE:
MARY PERFORMED SERVICES
AND RECEIVED $4,500 IN CASH
QUESTIONS #1 & #2
Understand the transaction,
Identify and Classify the affected
accounts
CONSULT.
CASH
FEES
ASSET
O.E.
REVENUE
QUESTION #3a
Increase or Decrease?
CONSULT.
FEES
INCREASE
CASH
INCREASE
QUESTION #3b
Does transaction balance?
ASSETS = LIAB.
CASH =
+$4,500 =
+ OWNER’S EQUITY
CONSULT.
FEES
+$4,500
It Balances!
Assets increased by $4,500 =
Owner’s Equity increased by $4,500
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
EQUIPMENT
CASH SUPPLIES
$3,000
BAL. $23,800
$800
+ $4,500
BAL. $28,300
$3,000
$800
$32,100
PROVING ACCOUNTING
EQUATION BALANCES:
LIAB.
ACCTS.
PAY.
BAL. $2,600
BAL.
$2,600
OWNER’S EQUITY
M. A.,
CONSULT.
CAPITAL
FEES
$25,000
+ $4,500
$25,000
$4,500
$32,100
EXPENSE EXAMPLE
MARY ADAMS PAID HER
ASSISTANT $750 IN WAGES
QUESTIONS #1 & #2
Understand the transaction,
Identify and Classify the affected
accounts
WAGES
CASH
EXPENSE
ASSET
O.E.
EXPENSE
QUESTION #3
Increase or Decrease?
WAGES
EXPENSE
INCREASE
CASH
DECREASE
QUESTION #3
Increase or Decrease?
WAGES
EXPENSE
CASH
BE CAREFUL! While incurring an
expense will increase the Expense account,
it will cause an overall
DECREASE IN OWNER’S EQUITY
QUESTION #3b
Does transaction balance?
ASSETS = LIAB.
CASH =
- $750
=
+ OWNER’S EQUITY
WAGES
EXPENSE
+$750
It Balances!
Assets decreased by $750 =
Owner’s Equity decreased by $750
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
EQUIPMENT
CASH SUPPLIES
$3,000
$800
BAL. $28,300
- $750
BAL. $27,550
$800
$3,000
$31,350
PROVING ACCOUNTING
EQUATION BALANCES:
LIAB.
OWNER’S EQUITY
EXPENSES
M. A.,
REV.
ACCTS.
PAY. CAPITAL
$4,500
$25,000
BAL. $2,600
+ $750
BAL. $2,600
$25,000
$4,500
$750
$2,600 + $25,000 + $4,500 $750 =
$31,350
REVENUE ON ACCOUNT
EXAMPLE:
MARY PERFORMED $6,000 OF
SERVICES ON ACCOUNT
QUESTIONS #1 & #2
Understand the transaction, Identify
and Classify the affected accounts
Mary has performed services for this
client. Client will be paying Mary
at a later date.
IT IS REVENUE EVEN THOUGH NO
CASH CHANGED HANDS TODAY!
QUESTIONS #1 & #2
Understand the transaction, Identify
and Classify the affected accounts
CONSULT.
FEES
ACCOUNTS
RECEIVABLE
O.E.
REVENUE
ASSET
QUESTION #3a
Increase or Decrease?
CONSULT.
FEES
INCREASE
ACCOUNTS
RECEIVABLE
INCREASE
QUESTION #3b
Does transaction balance?
ASSETS
= LIAB.
ACCTS.
=
RECEIVABLE
+$6,000
=
+
OWNER’S EQUITY
CONSULT.
FEES
+$6,000
It Balances!
Assets increased by $6,000 =
Owner’s Equity increased by $6,000
PROVING ACCOUNTING
EQUATION BALANCES:
CASH
BAL. $27,550
BAL. $27,550
ASSETS:
ACCTS. SUPPLIES
REC.
$800
+ $6,000
$6,000
$800
$37,350
EQUIP.
$3,000
$3,000
PROVING ACCOUNTING
EQUATION BALANCES:
LIAB.
OWNER’S EQUITY
EXPENSES
M. A.,
REV.
ACCTS.
PAY. CAPITAL
BAL. $2,600
$4,500
$750
$25,000
+ $6,000
BAL. $2,600
$25,000 $10,500
$750
$2,600 + $25,000 + $10,500 $750
= $37,350
CUSTOMER PAYMENT
EXAMPLE
RECEIVED $2,500 IN CASH FOR
SERVICES PERFORMED IN
PREVIOUS TRANSACTION
QUESTIONS #1 & #2
Understand the transaction, Identify
and Classify the affected accounts
When Mary provided the consulting
services, this client agreed to pay
at a later date.
TODAY THEY GAVE MARY CASH
OF $2,500 AS A PARTIAL PAYMENT.
QUESTIONS #1 & #2
Understand the transaction, Identify
and Classify the affected accounts
CASH
ASSET
ACCOUNTS
RECEIVABLE
ASSET
QUESTION #3a
Increase or Decrease?
CASH
INCREASE
ACCOUNTS
RECEIVABLE
DECREASE
QUESTION #3b
Does transaction balance?
CASH
+$2,500
ASSETS
ACCTS. REC.
-$2,500
= LIAB.
=
=
Yes!
Total Assets stayed the same.
One Asset increased, the other
decreased. No change in
Liabilities or Owner’s Equity
+
O. E.
PROVING ACCOUNTING
EQUATION BALANCES:
CASH
BAL. $27,550
+$2,500
BAL. $30,050
ASSETS:
ACCTS. SUPPLIES
REC.
$6,000
$800
-$2,500
$3,500
$800
$37,350
EQUIP.
$3,000
$3,000
PROVING ACCOUNTING
EQUATION BALANCES:
LIAB.
OWNER’S EQUITY
EXPENSES
M. A.,
REV.
ACCTS.
PAY. CAPITAL
BAL. $2,600
$750
$25,000 $10,500
BAL.
$2,600
$25,000
$10,500
$750
No Change to Right Side of Equation.
Still = $37,350
DRAWING EXAMPLE:
MARY WITHDREW $1,500
FOR PERSONAL EXPENSES
QUESTIONS #1 & #2
Understand the transaction, Identify
and Classify the affected accounts
Mary is withdrawing some of her
equity in the business by taking home an
asset (Cash). This will reduce the Assets &
reduce her Owner’s Equity.
QUESTIONS #1 & #2
Understand the transaction,
Identify and Classify the affected
accounts
M. A.,
CASH
DRAWING
ASSET
O.E.
DRAWING
QUESTION #3a
Increase or Decrease?
M. A.,
DRAWING
INCREASE
CASH
DECREASE
QUESTION #3a
Increase or Decrease?
M. A.,
DRAWING
CASH
BE CAREFUL! Just like Expenses,
Drawing account will increase in this situation,
but it will cause an overall
DECREASE IN OWNER’S EQUITY.
QUESTION #3b
Does transaction balance?
ASSETS
= LIAB.
CASH
=
-$1,500
=
+
OWNER’S EQUITY
M.A.,
DRAWING
+$1,500
It Balances!
Assets decreased by $1,500 =
Owner’s Eq. decreased by $1,500
PROVING ACCOUNTING
EQUATION BALANCES:
CASH
BAL. $30,050
-$1,500
BAL. $28,550
ASSETS:
ACCTS. SUPPLIES
REC.
$3,500
$800
$3,500
$35,850
$800
EQUIP.
$3,000
$3,000
PROVING ACCOUNTING
EQUATION BALANCES:
LIAB.
OWNER’S EQUITY
M. A.,
REV.
EXP.
ACCTS. M. A.,
CAP. DRAWING
PAY.
BAL. $2,600 $25,000
$10,500 $750
+$1,500
BAL. $2,600 $25,000
$1,500 $10,500 $750
$2,600 + $25,000 - $1,500 + $10,500 -$750
= $35,850
FINANCIAL STATEMENTS
THREE COMMONLY PREPARED
FINANCIAL STATEMENTS:
o INCOME STATEMENT
o STATEMENT OF OWNER’S EQUITY
o BALANCE SHEET
INCOME STATEMENT
Reports the profitability of business
operations
For a specific period of time
Expenses are subtracted from Revenues
to determine Net Income/Loss
Also called Profit and Loss Statement or
Operating Statement
Jessica Jane’s Campus Delivery
Income Statement
For Month Ended June 30, 20--
Financial Statement headings:
1st line: Name of Company
2nd line: Title of statement
3rd line: Time period
or specific date
Jessica Jane’s Campus Delivery
Income Statement
For Month Ended June 30, 20--
This column is used
for listing items
to be totaled
Jessica Jane’s Campus Delivery
Income Statement
For Month Ended June 30, 20--
This column is used
for Totals
Jessica Jane’s Campus Delivery
Income Statement
For Month Ended June 30, 20-Revenues:
Consulting Fees
First item at the top of
a column should include
“$”
$2,150
Jessica Jane’s Campus Delivery
Income Statement
For Month Ended June 30, 20-Revenues:
Consulting Fees
Expenses:
Wages Expense
Rent Expense
Telephone Expense
Total Expenses
$2,150
$ 650
200
50
900
Underline before totaling
Jessica Jane’s Campus Delivery
Income Statement
For Month Ended June 30, 20-Revenues:
Consulting Fees
Expenses:
Wages Expense
Rent Expense
Telephone Expense
Total Expenses
Net Income
$2,150
$ 650
200
50
900
$1,250
Revenues are greater than Expenses,
therefore total is called NET INCOME
Jessica Jane’s Campus Delivery
Income Statement
For Month Ended June 30, 20-Revenues:
Consulting Fees
Expenses:
Wages Expense
Rent Expense
Telephone Expense
Total Expenses
Net Income
Double underline
$2,150
$ 650
200
50
900
$1,250
STATEMENT OF OWNER’S
EQUITY
Reports the activities that affected
Owner’s Equity
For a specific period of time
Uses Net Income from Income Statement
Jessica Jane’s Campus Delivery
Statement of Owner’s Equity
For Month Ended June 30, 20-Jessica Jane, capital, June 1, 20-Net Income for June
$2,000
$1,250
Instead of showing Revenue increasing &
Expenses decreasing the Owner’s Equity,
this statement uses the net effect
(Net Income/Loss) from the
Income Statement.
Jessica Jane’s Campus Delivery
Statement of Owner’s Equity
For Month Ended June 30, 20-Jessica Jane, capital, June 1, 20-Net Income for June
Less withdrawal for June
Increase in Capital
$2,000
$1,250
150
$1,250 Net Income - $150 Withdrawal =
$1,100 increase in Capital
1,100
Jessica Jane’s Campus Delivery
Statement of Owner’s Equity
For Month Ended June 30, 20-Jessica Jane, capital, June 1, 20-Net Income for June
Less withdrawal for June
Increase in Capital
Jessica Jane, capital, June 30, 20--
$2,000
$1,250
150
1,100
$3,100
$2,000 beginning O. E. + $1,100 increase =
$3,100
BALANCE SHEET
Confirms the accounting equation has
remained in balance
Includes: Assets, Liabilities, Owner’s
Equity
Also called Statement of Financial
Position or Statement of Financial
Condition
Jessica Jane’s Campus Delivery
Balance Sheet
June 30, 20--
Balance Sheet reports Assets,
Liabilities and Owner’s Equity
on a SPECIFIC DATE,
Not a period of time
Jessica Jane’s Campus Delivery
Balance Sheet
June 30, 20-Assets
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Delivery Equipment
Total Assets
$ 370
650
80
200
3,600
$4,900
Liabilities
Accounts Payable
$1,800
Owner’s Equity
Jessica Jane, Capital
3,100
Total Liabilities and
Owner’s Equity
$4,900
It Balances!!!
ACCOUNTING PROCESS
THREE BASIC PHASES:
oInput
oProcessing
oOutput
INPUT
Transactions
provide the
necessary
input
PROCESSING
•Identify accounts
•Classify accounts
•Increase or Decrease?
•Enter transaction and
verify balance
OUTPUT
INCOME
STATEMENT
STATEMENT OF
OWNER’S EQUITY
REVENUES
BEGINNING CAPITAL
minus
plus
EXPENSES
equals
INVESTMENTS
plus
NET INCOME
minus
NET INCOME
WITHDRAWALS
equals
ENDING CAPITAL
OUTPUT
BALANCE SHEET
ASSETS
equal
LIABILITES
plus
OWNER’S EQUITY
(Ending Capital)