Chapter 1 The Nature of Accounting
Chapter 1 BASIC ACCOUNTING IN ACTION
I. Overview of Accounting.
A. Define accounting.
1. Accounting is considered the language of business. This is because in today’s business world it is impossible to get by without accounting. Every organization—whether profit making or not-for-profit—must make good decisions in order to survive. Accounting provides information that is the basis for making those decisions.
2. Definition of Accounting: The Accounting Process as the process of Analyzing (Identifying business transactions); Classifying); (Determining the specific accounts involved and deciding whether the accounts should be increased or decreased); Recording (Listing the details in a permanent record (either in writing or electronically); Summarizing (After a period of time, showing the results of a group of transactions in the form of financial statements); and Interpreting (Drawing conclusions and making decisions from financial statements). Notice how the process in illustrated in a circular pattern because accounting is performed in cycles. Once a cycle is complete, the process begins all over again. Note the distinction between Accounting and Bookkeeping where bookkeeping involves just the recording element of the accounting process and accounting involves classifying, analyzing, interpreting accounting data.
3. Accounting also provides Economic Information which means it is providing information dealing with financial or money-related activities to permit individuals and organizations to make informed judgments and decisions.
4. Identify users of accounting. Some questions asked by internal and external users of accounting data:
a) Internal users of accounting information are managers who plan, organize, and run a business.
b) External users include investors (owners) who use accounting information to make decisions to buy, hold, or sell stock and creditors such as supplies and bankers who use accounting information to evaluate the risks of granting credit or lending money.
B. History of Accounting—the double-entry system of accounting that is the basis of our modern accounting system was first introduced in 1494 by an Italian monk named Luca Pacioli who was a mathematician. He published a mathematics book where he devoted a couple of chapters in that book to the double-entry system of accounting during a period of time when merchants were making expeditions. Explorations were accomplished by obtaining funding from various sources sponsoring the expeditions. Along with the funding, there would be a need to account for the funds that were used on these voyages which accounts for the timing of the publishing of the double-entry system of accounting. Pacioli did not invent the double entry accounting system. He was simply the first to describe it in print. Therefore he has the distinction of being called the Father of Accounting.
C. II. The Accounting Equation.
A. The system of accounting for a business begins by asking the questions: What are the resources of a business? Where do the resources come from?
|WHAT ARE THE RESOURCES OF A BUSINESS? | |WHERE DO THE RESOURCES COME FROM? |
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| | | |
| | | |
|(The cost of everything that a business owns or controls) | |(Those who have claims or rights to the assets) |
| | | | | |
|Cash |+ |Accounts Receivable |+ |Supplies |
|Assets |- |Liabilities |= |Owner’s Equity |
|Assets |- |Owner’s Equity |= |Liabilities |
For example to find the following missing parts, you would solve as follows:
|Assets |Liabilities |Owner’s Equity |
|$36,000 |$16,420 |$______ |
|$______ |$19,950 |$20,560 |
|$69,860 |$______ |$40,290 |
|Assets |- |Liabilities |= |Owner’s Equity |
|$36,000 |- |$16,420 |= |$19,580 |
|Assets |= |Liabilities |+ |Owner’s Equity |
|$40,510 |= |$19,950 |+ |$20,560 |
|Assets |- |Owner’s Equity |= |Liabilities |
|$69,860 |- |$40,290 |= |$29,570 |
B. Accepted concepts and principles are generally accepted accounting principles (GAAP), which are rules that govern how accounting personnel measure, process, and report financial information. Following are concepts that are specifically covered in Chapter 1:
1. The entity concept states that the business is separate from its owner(s). So even though, for a sole proprietor or a partnership, the business and the owner are not separate legal entities, for accounting purposes, the assets and liabilities are separated for those that belong personally to the owner and those that are accounted for in the business and any other business. Therefore, if an owner has more than one business, they are each accounted for in separate sets of records.
2. The cost principle states that all assets, when purchased, are recorded at their actual cost, regardless of market value.
3. The realization principle states that a business earns (realizes) revenue when goods or services are sold to customers, even though cash may not be collected until sometime in the future. Along with the concept that revenues are recognized when they are earned is also the rule that expenses will be recognized when they are incurred which may be a different time than when the cash is paid.
4. The stable monetary unit concept states that only transaction data that can be expressed in terms of money be included in the accounting records.
C. Record transactions in the accounting equation. Note from textbook examples that accounts (individual records or subdivisions used to record and summarize information related to each asset, each liability, and each aspect of owner’s equity) are entered under the respective classification that relates to the business transactions (any activity that changes the value of a firm’s assets, liabilities, or owner’s equity. The accounting equation must always balance. The effects of every transaction can be stated in terms of increases and/or decreases in the basic accounting elements. A particular transaction may affect only one side of the equation, but still leave the equation balanced. The steps to recording business transactions are as follows where GAAP will be used so that the transactions are properly recorded and recognized:
1. Step 1 in recording business transactions involves the first two parts of the definition of accounting which are to analyze and classify the transactions. Refer to the bottom of the handout on page 2 for the acronym, ACID for the questions to ask when analyzing a transaction:
a) What ACCOUNTS are involved? For this handout example, the choices are Cash, Accounts Receivable, Supplies, Equipment, Accounts Payable, Notes Payable, Capital, Revenues, and Expenses. Notice the word is “Accounts” (plural) which means that it will take two or more accounts to keep the accounting equation—A = L + OE—in balance for any business transactions. The textbook refers to this concept as the dual effect because every business transaction has at least two effects on the accounting equation. This is the double-entry technique, which ensures that after recording a transaction, the accounting equation will still balance.
b) What are the CLASSIFICATIONS of the accounts? The three classifications are always the three elements of the accounting equation—Assets, Liabilities, and Owner’s Equity. A particular business transaction may under only one classification, two classifications, or all three classifications. The dual effect can change elements on both sides of the accounting equation or just on one side. A common misconception is that the dual effect means that both sides of the accounting are affected by each transaction. But as you will see, there are transactions that are totally on just one side of the accounting equation.
c) Are the accounts INCREASED (+)? Or …
d) Are the accounts DECREASED (-)?
2. Step 2 involves recording the business transactions in permanent records. The permanent records will be introduced in Chapter 2 what are the journal and the ledger. The first chapter uses the accounting equation format (Chapter 1) and the T-account format (Chapter 2) to help grasp the basic concepts of accounting as these first two chapters are extremely vital chapters as they are covering the fundamental foundation of accounting—the double-entry system of accounting. Now complete the handout applying these first two steps in recording the business transactions that are listed on the bottom of the handout as follows:
a) Owner invested $10,000 cash to start a business.
1. Ask: What Accounts are involved? Cash and Capital. Since the owner invested (supplied) the asset to the company, the owner has the right or claim to the asset. The asset now becomes a business asset and not the owner’s personal asset according to the business entity concept stated above. The dollar amount will be entered under the owner’s capital account to show that the owner made an investment into the company and that the owner has the right or claim or this asset.
2. Ask: What are the Classifications of these accounts? Cash is an asset and capital is a part of the owner’s equity.
3. Ask: Are the accounts Increased or Decreased? Cash is increased as there was no cash in the business prior to this transaction and now there is $10,000. So enter +10,000 under the cash column next to letter (a). Also the owner’s capital account is increased so enter +10,000 under the capital column. This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|+ | | | |+ |
4. After every transaction, you should check to see if the accounting equation is in balance. To do so add up the total assets and the total equities to make sure the accounting equation balances and this can be done as follows:
|Total | |Assets |= |Equities | |Total |
|10,000 |= |+10,000 |= |+10,000 |= |10,000 |
b) Company purchased $500 supplies on account.
1. Ask: What Accounts are involved? Supplies and Accounts Payable. The terms “on account” is an indicator that a purchase has been charged on account. The company has established a charge account like at Staples, Office Depot, etc. and will probably be billed once a month or so for purchases made on that account.
2. Ask: What are the Classifications of these accounts? Supplies are an asset and accounts payable is a liability. A question that often comes up here is why are the supplies an asset and not an expense of doing business? Supplies are considered a prepaid expense and will be expensed as they are used. The key to determining if an expenditure should be classified as an asset or an expense is whether the item provides a future benefit to the business. The supplies may be used over a period of several months and therefore would have a future benefit so they are classified as an asset.
3. Ask: Are the accounts Increased or Decreased? Both supplies and accounts payable are being increased as there were no supplies or amounts owed to creditors prior to this transaction and now both have increased $500. Therefore enter a +500 under the Supplies column and the Accounts Payable column on the line with the letter (b) This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|+ | |+ | | |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|10,500 |= |+10,000+500 |= |+500+10,000 |= |10,500 |
c) Company paid $1,000 rent expense on a building.
1. Ask: What Accounts are involved? Cash and Expenses (Rent Expense).Expenses are actually a category and each expense will be given a separate account with the name of the expense for preparing financial statements and for tax purposes where individual expenses must be listed with amounts. For this chapter and for homework purposes, there is a description column next to the owner’s equity section to identify the name of the revenue and the name of the expense for financial statement preparation purposes. Rent expense is considered an expense when just paying the monthly rent as there is no future benefit in that expenditure. If several months of rent were paid for in advance, then there is future benefit and it would be recorded as an asset called Prepaid Rent and expensed as each month amount was used.
2. Ask: What are the Classifications of these accounts? Cash is an asset and expenses are part of owner’s equity. Expenses decrease owner’s equity (reduces the owner’s claim to assets from generating revenues) and are entered with a minus sign to show that it is decreasing the owner’s equity section of the accounting equation. Another way to look as to why expenses decrease owner’s equity is because cash is paid out (or a debt is created) but nothing goes back into the business in its place. There is no future benefit as with supplies or equipment expenditures.
3. Ask: Are the accounts Increased or Decreased? Both the cash and the owner’s equity are decreasing. Note that expenses, themselves, are increasing as did not have expenses before and now do have them. But the owner’s equity is decreasing with the operating expenses to run a business. Therefore, enter a -1,000 under the cash column and a -1,000 under the expenses column on the line with the letter (c). This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|- | | | |- |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|9,500 |= |+9,000+500 |= |+500+10,000-1,000 |= |9,500 |
d) Company purchased $15,000 of equipment paying $2,000 down and signing a note for the remainder.
1. Ask: What Accounts are involved? Equipment, Cash and Notes Payable. This would be a notes payable rather than accounts payable as is a formal written promise to pay. Notice how this transaction takes three accounts. The dual effect means that it takes two or more accounts to enter the transaction and in this case three accounts were involved.
2. Ask: What are the Classifications of these accounts? Equipment and cash are assets and notes payable is a liability.
3. Ask: Are the accounts Increased or Decreased? Cash is decreased and entered as a -2,000, equipment is increased +15,000 (the cost of the equipment—see cost principle above), and notes payable is increased as did not have a notes payable before the transaction with a +13,000 and now have one column on the line with the letter (d) This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|-,+ | |+ | | |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|22,500 |= |+7,000+500+15,000 |= |+500+13,000+10,000-1,000 |= |22,500 |
e) Company rendered services for cash of $2,500.
1. Ask: What Accounts are involved? Cash and Revenues (Fees Earned, Service Revenue, Income from Services, etc.). Revenues are the name of a category that always increase owner’s equity since the owner gets to the claim for the income from carrying out the major activity of a business—which increases the value of the business. The specific type of revenue is given the name of the account to describe it for financial statement purposes such as fees earned, fares earned, service revenue, interest income, rent income, sales, etc.
2. Ask: What are the Classifications of these accounts? Cash is an asset and revenues are a part of owner’s equity.
3. Ask: Are the accounts Increased or Decreased? Both cash and revenues are being increased and entered with a +2,500 under the Cash and the Revenues column on the line with the letter (e). This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|+ | | | |+ |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|25,000 |= |+9,500+500+15,000 |= |+500+13,000+10,000+2,500-1,000 |= |25,000 |
f) Company rendered services billing customers for $5,000.
1. Ask: What Accounts are involved? Accounts Receivable and Revenues (Fees Earned, Service Revenue, Income from Services, etc.).The realization principle states that revenues must be recognized when earned even though cash may not be received until later.
2. Ask: What are the Classifications of these accounts? Accounts receivable is an asset and revenues are a part of owner’s equity.
3. Ask: Are the accounts Increased or Decreased? Both accounts receivable and revenues are being increased Therefore enter a +5,000 under the Accounts Receivable column and the Revenues column on the line with the letter (f). This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|+ | | | |+ |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|30,000 |= |+9,500+5,000+500+15,000 |= |+500+13,000+10,000+7,500-1,000 |= |30,000 |
g) Company paid $250 advertising expense.
1. Ask: What Accounts are involved? Cash and Expenses (Advertising Expense).
2. Ask: What are the Classifications of these accounts? Cash is an asset and advertising expense is a part of owner’s equity.. Remember the key to determining if an expenditure should be classified as an asset or an expense is whether the item provides a future benefit to the business. If the advertising expenditure was for a current advertisement which is assumed here with the low cost figure, then there is no future benefit and therefore it would be expensed. If several months advertising were paid for in advance and the problem would need to state that, then there would be a future benefit and would be classified as an asset, Prepaid Advertising and would be expensed as each month passed.
3. Ask: Are the accounts Increased or Decreased? Both cash and owner’s equity where the expense is classified under are being decreased by $250. Therefore enter a -250 under the Cash column and the Expenses column on the line with the letter (g).The expenses themselves are increasing as now the total expenses would be 1,250. But the total expenses reduce the owner’s equity by the total 1,250. This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|- | | | |- |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|29,750 |= |+9,250+5,000+500+15,000 |= |+500+13,000+10,000+7,500-1,250 |= |29,750 |
h) Company paid $850 wages expense.
1. Ask: What Accounts are involved? Cash and Expenses (Wages Expense).
2. Ask: What are the Classifications of these accounts? Cash is an asset and wages expense is a part of owner’s equity. The wages expense definitely does not provide a future benefit as employees are paid after they provide work for the business.
3. Ask: Are the accounts Increased or Decreased? Both cash and owner’s equity where the expense is classified under are being decreased by $850. Therefore enter a -850 under the Cash column and the Expenses column on the line with the letter (h).The expenses themselves are increasing as now the total expenses would be 2,100. This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|- | | | |- |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|28,900 |= |+8,400+5,000+500+15,000 |= |+500+13,000+10,000+7,500-2,100 |= |28,900 |
i) Company received a bill of $275 for utilities but will not pay the bill until the following month.
1. Ask: What Accounts are involved? Accounts Payable and Expenses (Utilities Expense). Refer to the explanation under the realization principle above that states that revenues are recognized when they are earned and likewise expenses will be recognized when they are incurred even though cash may be paid at a different time. Therefore, this transaction needs to be recorded as soon as it is received so that the expense is recognized even if the expense will be paid before the month is over. THIS IS A TRANSACTION THAT IS HEAVILY MISSED. What many students have done in the past is just ignore this transaction when the bill is received but then accounting principles are being VIOLATED as expenses need to be recognized and therefore recorded when they are incurred.
2. Ask: What are the Classifications of these accounts? Accounts Payable is a liability and Utilities Expense is an expense which is part of owner’s equity.
3. Ask: Are the accounts Increased or Decreased? This transaction is an example of a transaction that all the accounts occur on the same side of the accounting equation. When this happens, one account or classification must increase and the other must decrease to keep the equation in balance. With this transaction, the Accounts Payable account in increased as the business has additional debt that is owed with this utilities bill. So the liabilities classification in increased. But the owner’s equity classification will decrease because expenses decrease owner’s equity. Therefore, the accounting equation is still in balance as there is an increase and a decrease on the SAME side of the accounting equation. This transaction can be shown as follows showing the dual effect and note that the total assets and total equities stay the same as after the transaction (h) as there was just an increase and a decrease on the same side so the overall totals stay the same.:
|A |= |L |+ |OE |
| | |+ | |- |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|28,900 |= |+8,400+5,000+500+15,000 |= |+775+13,000+10,000+7,500-2,375 |= |28,900 |
5. To see transactions that just affect the ASSET side of the accounting equation, refer to Transaction (C ) on the bottom of page 7 and the top of page 8 and Transaction (K) on page 11 of the textbook. Transaction (C ) is a purchase of supplies for cash and therefore cash is decreased and supplies are increased. This could also happen if equipment is purchased with cash. Transaction (K) is the transaction when a customer makes a payment on their account. Note on page 11 that cash is increased and accounts receivable in decreased. This is a transaction that is often missed as the transaction reads “Received $3000 cash as partial payment for services performed on account. The key words here are “on account” which is the clue that it needs to reduce an accounts receivable. A common incorrect entry is to increase the revenues. But that will double count the revenues account and therefore you will be paying double taxes on the same transaction. Also the customer will not be happy as they will be billed again as if they had not made a payment on their account. Both of these transactions are what is called a shift in assets, that is, the individual assets did change but the total dollar value of the assets remains the same. These shift in assets transactions can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|-,+ or +,-| | | | |
j) Owner takes a draw of $1,000.
1. Ask: What Accounts are involved? Cash and Owner’s Capital (Owner’s Drawing account). Unlike employees, the owner of the business does not receive a salary as a sole proprietorship is not a separate legal entity. The owner then will withdraw cash or other assets from the business but it cannot be an expense. An owner’s withdrawal—the removal of business assets for personal use—has the dual effect of decreasing both the asset taken and the value of the business and is show under the owner’s Capital account as a decrease to that account. That way it still shows a decrease to the owner’s equity but under the capital section, NOT the expense section. The owner takes assets out of the business and does not put anything back in its place so it reduces owner’s equity.
2. Ask: What are the Classifications of these accounts? Cash is an asset and owner’s capital (Drawing) is a part of the owner’s equity.
3. Ask: Are the accounts Increased or Decreased? Both cash and owner’s equity are being decreased. Therefore enter a -1,000 under the Cash column and the Owner’s Capital column on the line with the letter (j) This transaction can be shown as follows showing the dual effect:
|A |= |L |+ |OE |
|- | | | |- |
4. Check that the accounting equation is in balance as follows:
|Total | |Assets |= |Equities | |Total |
|27,900 |= |+7,400+5,000+500+15,000 |= |+775+13,000+9,000+7,500-2,375 |= |27,900 |
Once all the transactions are entered for a period, the individual accounts are totaled and then the total assets are added together and the total equities are added together like show under number 4 above to prove that the accounting equation is in balance.
Summary of transactions example:
|ASSETS |= |LIABILITIES |+ |OWNER'S EQUITY |
|Cash |+ |Acco|+ |Supplies |+ |
| | |unts| | | |
| | |Rece| | | |
| | |ivab| | | |
| | |le | | | |
Follow through the transactions in the chapter on a transaction spreadsheet like shown above. I have found that doing this helps to cement the concepts before you do the homework problems demonstrating your understanding of the concepts. In my teaching career with accounting, this concept is very evident: I HEAR AND I FORGET. I SEE AND I REMEMBER. I DO AND I UNDERSTAND. I have found that it does take the actual act of completing the problems and the homework to get a good understanding of the accounting process. Note at the bottom of the summary on page 19 of the textbook showing the balances in the accounts, that EACH COLUMN TOTAL IS DOUBLE-RULED (DOUBLE-UNDERLINED). This is a common accounting practice to always double-underlined totals to show the reader that this number represents a total.
III. Financial Statements. Once the accounting equation report with the transactions is completed and balanced, then the financial statements can be prepared. The financial statements must be prepared in a particular order as numbers from one statement are needed for the next statement: First, the Income Statement is prepared. As shown on the handout, page 3, the numbers for the income statement come from the Revenues and Expenses columns of the accounting equation list of transactions. Second, the Statement of Owner’s Equity is prepared which uses the net income or net loss figure from the Income Statement as well as the numbers in the Capital column of the accounting equation list of transactions. Third, the Balance Sheet is prepared which uses the balances of all the assets and liability accounts as well as the final number which is the owner’s ending capital balance from the Statement of Owner’s Equity. PLEASE MAKE A NOTE THAT SINCE THE FINANCIAL STATEMENTS ARE THE END PRODUCTS OF THE ACCOUNTING PROCESS which are prepared for users of the financials statements, YOU DO NOT WANT TO HAVE ANY ABBREVIATIONS ON THESE REPORTS. Also the proper currency format should be used which means the dollar sign will be used at the top of a column and in the totals (see textbook examples). Refer to illustration below that shows the Relationship of Owner’s Equity Accounts and which accounts are entered in to the different financial statements:
|Assets |= |Liabilities |+ |Owner's Equity |
|Cash |
| |
|RELATIONSHIP OF OWNER'S EQUITY ACCOUNTS |
| |
|BALANCE SHEET |
| |
| |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | |SHOWN ON INCOME STATEMENT | |
|SHOWN ON STATEMENT OF OWNER'S EQUITY | | | | |
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A. The income statement—a summary of a businesses revenue and expenses for a specific period of time, such as a month, a quarter, or a year.
1. Identify the components of the income statement. The format of the income statement is revenue minus expenses equals net income (or net loss).
2. Describe the heading. Heading information tells who, what, and when.
a. Who: answers the question—name of the firm not the name of the owner. For example a company could be Gary Parker, CPA. Professionals use their name in the name of the company along with their title. But on the financial statements when referring to the owner’s capital, it is just the name of the owner without the title so it would just be Gary Parker.
b. What: answers the question—name of the report and would be Income Statement for this report.
c. When: answers the question—dealing with the date or the accounting period just ended. The Income Statement is the accounting period just ended.
3. Investments and withdrawals are not included. Only revenues and expenses appear on the income statement. Note the first the category of “Revenue:” is shown and then the revenue account(s) are listed. Then the category of “Expenses:” is listed and then the individual expense accounts are listed. Note that there is not a line between the revenues and expenses but as soon as the revenues are listed, the next line is the word, “Expenses:”
4. From examples in the textbook: Note how the INDENTS are done on this statement:
a. The words Revenues, Expenses, and Net income are next to the margin of the statement.
b. The list of revenues and expenses are indented from the heading.
c. The words, “Total expenses,” are indented from the final expense account.
5. Revenues (if more than one) and expenses are listed IN ORDER OF SIZE—LARGEST TO SMALLEST. This is so that the users of the financial statements will see these in order of magnitude so they know which accounts are producing the largest revenues (if more than one) and which are the largest expenses in the operations of the business. Again the first column will list the amounts if there is more than one of a category and the second column shows the total of the category.
6. NOTE FROM THE EXAMPLES THAT ONLY THE “FIRST” WORD ON A LINE IS CAPITALIZED unless the word is a proper noun like the name of a person or a month in the year. An account name is not a proper noun so the owner’s capital should not be capitalized but the owner’s name would be capitalized. Also earnings for a corporation in NOT capitalized.
7. NET INCOME = REVENUES – EXPENSES. If the dollar value of the revenues is greater than the dollar value of the expenses, then the company has a “Net income,” and those words are written on the line after “Total expenses” without skipping any lines. If the expenses are greater than the revenues, then the company has a “Net Loss,” and those words are written on the line after “Total expenses” without skipping any lines. Also the dollar amount of the “Net loss” will be shown in parenthesis as is a negative number.
8. NOTE the NET INCOME or NET LOSS FIGURE (AMOUNT) is DOUBLE-UNDERLINED as that is the final total of the statement.
B. The statement of owner’s equity—a summary of the changes that have occurred in owner’s equity during a period of time, such as a month, a quarter, or a year for a sole-proprietorship (Statement of Retained Earnings for a corportation).
1. Identify the components of the statement of owner’s equity.
a. Owner’s capital at the beginning of the period.
b. Any new owner investments into the business.
c. The net income or net loss figure from the Income Statement. From textbook examples, note the net income from the Income Statement is inserted into the Statement of Owner’s Equity showing why the Income Statement must be prepared before the Statement of Owner’s Equity.
d. Owner’s withdrawals are deducted from the net income or the net loss for the period as shows the owner is withdrawal some of the earnings. But even if the business has a net loss, the owner may have taken drawings as it takes assets to be able to withdraw—not net income.
e. The last component is the total owner’s capital at the end of the period.
2. The statement of owner’s equity has the same type of heading as the income statement.
a. The first line shows the Who: Name of the company.
b. The second line shows the What: Name of the financial statement.
c. The third line shows the When: Period of time the statement covers.
3. NOTE FROM THE EXAMPLES THAT ONLY THE “FIRST” WORD ON A LINE IS CAPITALIZED unless the word is a proper noun like the name of a person or a month in the year. An account name is not a proper noun so the owner’s capital should not be capitalized but the owner’s name would be capitalized.
4. The FIRST LINE of the statement shows the owner’s name (not the name of the company so do not include the owner’s title) with the full date at the beginning of the period (month, day, and year is optional in this textbook). The LAST LINE of the statement shows the owner’s name (not the name of the company so do not include the owner’s title) with the full date at the END of the period (month, day, and year is optional in this textbook).
5. Identify the formula for ending capital:
a. The capital at the beginning of the period. If this is the company’s first month of operation, then the amount would be the owner’s initial investment. This amount goes into the second column.
b. In the first column is the net income or net loss amount.
c. – withdrawals for the period (listed in the first column),
d. = a subtotal that is not labeled in the textbook example.
e. The capital at the beginning of the period is added to an increase in capital for the capital at the end of the period. Alternatively, a decrease in capital is subtracted from the capital at the beginning of the period to arrive at the amount of capital at the end of the period.
6. NOTE the ending owner’s capital amount is DOUBLE-UNDERLINED as this is the final total of the statement.
C. The balance sheet—a listing of a firm’s assets, liabilities, and owner’s equity at a specific point in time
1. Identify the components of the balance sheet.
a) The balance sheet lists the assets IN ORDER OF LIQUIDITY (how fast an asset will be turned into cash—that is why cash is listed first as that asset is already cash). After cash is accounts receivable as that amount should be collect in a short period of time in the form of cash from the company’s customers. Next are the prepaid expenses such as supplies, prepaid rent, prepaid advertising, prepaid insurance, etc. which will be used by the company usually within one year or less. The last items would the long-term assets such as equipment that will be kept and used by the business usually longer than a year.
b) Next the balance sheet lists the liabilities of the company. There is not a set order for the liabilities. Some companies always list accounts payable first and then notes payable as that is usually the order in which they will be paid. Other companies will list the liabilities according to the legal liability to pay them so they would list notes payable before accounts payable.
c) Finally the balance sheet shows the owner’s equity which would just be the owner’s capital amount at the end of the period that is calculated on the statement of owner’s equity and brought down into the balance sheet. NOTE that the owner’s capital amount does not show a date next to it as is done on the statement of owner’s equity because the date that is on the heading of the balance sheet is giving the amount in accounts as of the last day of the period so the date does not need to be shown again in that section of the balance sheet.
2. The Balance Sheet is a detailed version of the accounting equation.
a) The first total of the balance sheet reflects the left side of the accounting equation (total assets) and since that is a total, the amount is DOUBLE-UNDERLINED.
b) The second total of the balance sheet express the right side of the accounting equation (total equities) which is labeled the two sections of the equities which is “Total liabilities and owner’s equity” and this amount is DOUBLE-UNDERLINED (REMEMBER that you do not abbreviate on financial statements so be sure and spell out the word “and”).
3. Refer to the heading of the Balance Sheet:.
a) The first line shows the Who: Name of the company.
b) The second line shows the What: Name of the financial statement.
c) The third line shows the When: NOTE THE DIFFERENCE here with the Balance Sheet than what was on the other two statements. Since the balance sheet is showing the “balances” (as the name of the financial statement implies), of the accounts on the last day of the accounting period, it only shows a SINGLE DATE IN TIME. A good way to think of this is that since it is showing balances, it cannot be over a period of time. Take cash, for example, where the balance in that account changes on a constant basis from day-to-day. So the number that shows on the balance sheet is the balance in the cash account at the end of the day on the last day of the accounting period.
4. This sequence that must be followed in preparing the statements illustrated:
a) The income statement must be prepared first to determine the net income figure which is entered into the statement of owner’s equity.
b) The statement of owner’s equity must be prepared next to determine the owner’s capital amount at the end of the period.
c) The balance sheet is prepared last as the ending owner’s capital amount that is calculated in the statement of owner’s equity is needed so that the balance sheet will balance. This is a part that makes accounting an exciting process when you come to the end of the balance sheet and IT BALANCES!!!! HURRAH!!!!!
A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time. The statement of cash flows reports (1) the cash effects of a company’s operations during a period, (2) it s investing transactions, (3) its financing transactions, (4) the net increase or decrease in cash during the period, and (5) the cash amount at the end of the period. CHAPTER 14 OF THE TEXTBOOK JUST COVERS THE STATEMENT OF CASH FLOWS. THEREFORE, THE PREPARATION TECHNIQUES ARE NOT DISCUSSED IN THIS CHAPTER.
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