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To understand accounting information, we need to know how an accounting system captures relevant data about transactions, and then classifies, records, and reports data.
Accounting Equation
Assets Assets are resources owned or controlled by a company. These resources are expected to yield future benefits. Examples are Web servers for an online services company, musical instruments for a rock band, and land for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of resources. A company that provides a service or product on credit is said to have an account receivable from that customer. Point: The phrases “on credit” and “on account” imply that the cash payment will occur at a future date. Liabilities Liabilities are creditors' claims on assets. These claims reflect company obligations to provide assets, products or services to others. The term payable refers to a liability that promises a future outflow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes payable to banks, and taxes payable to the government. Equity Equity is the owner's claim on assets. Equity is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity. A corporation's equity—often called stockholders' or shareholders' equity—has two parts: contributed capital and retained earnings. Contributed capitalTotal amount of cash and other assets received from stockholders in exchange for stock; also called paid-in capital. refers to the amount that stockholders invest in the company—included under the title common stock. Retained earnings refer to income(See net income.) (revenues less expenses) that is not distributed to its stockholders. The distribution of assets to stockholders is called dividendsUnpaid dividend on cumulative preferred stock; must be paid before any regular dividends on preferred stock and before any dividends on common stock., which reduce retained earnings. RevenuesExpenditures reported on the current income statement as an expense because they do not provide benefits in future periods. increase retained earnings and are the assets earned from a company's earnings activities. Examples are consulting services provided, sales of products, facilities rented to others, and commissions from services. ExpensesOutflows or using up of assets as part of operations of a business to generate sales. decrease retained earnings and are the cost of assets or services used to earn revenues. Examples are costs of employee time, use of supplies, and advertising, utilities, and insurance services from others. In sum, retained earnings is the accumulated revenues less the accumulated expenses and dividends since the company began. This breakdown of equity yields the following expanded accounting equationAssets = Liabilities + Equity; Equity equals [Owner capital - Owner withdrawals + Revenues - Expenses] for a noncorporation; Equity equals [Contributed capital + Retained earnings + Revenues - Expenses] for a corporation where dividends are subtracted from retained earnings.:
Key terms are printed in bold and defined again in the end-of-book glossary. Net incomeAmount earned after subtracting all expenses necessary for and matched with sales for a period; also called income, profit, or earnings. occurs when revenues exceed expenses. Net income increases equity. A net lossExcess of expenses over revenues for a period. occurs when expenses exceed revenues, which decreases equity.
Transaction AnalysisBusiness activities can be described in terms of transactions and events. External transactionsExchanges of economic value between one entity and another entity. are exchanges of value between two entities, which yield changes in the accounting equation. Internal transactionsActivities within an organization that can affect the accounting equation. are exchanges within an entity; they can also affect the accounting equation. An example is a company's use of its supplies, which are reported as expenses when used. EventsHappenings that both affect an organization’s financial position and can be reliably measured. refer to happenings that affect an entity's accounting equation and can be reliably measured. They include business events such as changes in the market value of certain assets and liabilities, and natural events such as floods and fires that destroy assets and create losses. They do not include, for example, the signing of service or product contracts, which by themselves do not impact the accounting equation.
This section uses the accounting equation to analyze 11 selected transactions and events of FastForward, a start-up consulting business, in its first month of operations. Remember that each transaction and event leaves the equation in balance and that assets always equal the sum of liabilities and equity. Transaction 1: Investment by Owner On December 1, Chuck Taylor forms a consulting business focused on assessing the performance of athletic footwear and accessories, which he names FastForward. He sets it up as a corporation. Taylor owns and manages the business. The marketing plan for the business is to focus primarily on consulting with sports clubs, amateur athletes, and others who place orders for athletic footwear and accessories with manufacturers. Taylor personally invests $30,000 cash in the new company and deposits the cash in a bank account opened under the name of FastForward. After this transaction, the cash (an asset) and the stockholders' equity each equal $30,000. The source of increase in equity is the owner's investment (stock issuance), which is included in the column titled Common Stock. The effect of this transaction on FastForward is reflected in the accounting equation as follows:
Point: There are 3 basic types of company operations: (1) Services — providing customer services for profit, (2) Merchandisers — buying products and re-selling them for profit, and (3) Manufacturers — creating products and selling them for profit. Transaction 2: Purchase Supplies for Cash FastForward uses $2,500 of its cash to buy supplies of brand name athletic footwear for performance testing over the next few months. This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It merely changes the form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The supplies of athletic footwear are assets because of the expected future benefits from the test results of their performance. This transaction is reflected in the accounting equation as follows:
Transaction 3: Purchase Equipment for Cash FastForward spends $26,000 to acquire equipment for testing athletic footwear. Like transaction 2, transaction 3 is an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its expected future benefits from testing athletic footwear. This purchase changes the makeup of assets but does not change the asset total. The accounting equation remains in balance.
Transaction 4: Purchase Supplies on Credit Taylor decides he needs more supplies of athletic footwear and accessories. These additional supplies total $7,100, but as we see from the accounting equation in transaction 3, FastForward has only $1,500 in cash. Taylor arranges to purchase them on credit from CalTech Supply Company. Thus, FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases assets by $7,100 in supplies, and liabilities (called accounts payable to CalTech Supply) increase by the same amount. The effects of this purchase follow:
Example: If FastForward pays $500 cash in transaction 4, how does this partial payment affect the liability to CalTech? What would be FastForward's cash balance? Answers: The liability to CalTech would be reduced to $6,600 and the cash balance would be reduced to $1,000. Transaction 5: Provide Services for Cash FastForward earns revenues by consulting with clients about test results on athletic footwear and accessories. It earns net income only if its revenues are greater than its expenses incurred in earning them. In one of its first jobs, FastForward provides consulting services to an athletic club and immediately collects $4,200 cash. The accounting equation reflects this increase in cash of $4,200 and in equity of $4,200. This increase in equity is identified in the far right column under Revenues because the cash received is earned by providing consulting services.
Transactions 6 and 7: Payment of Expenses in Cash FastForward pays $1,000 rent to the landlord of the building where its facilities are located. Paying this amount allows FastForward to occupy the space for the month of December. The rental payment is reflected in the following accounting equation as transaction 6. FastForward also pays the biweekly $700 salary of the company's only employee. This is reflected in the accounting equation as transaction 7. Both transactions 6 and 7 are December expenses for FastForward. The costs of both rent and salary are expenses, as opposed to assets, because their benefits are used in December (they have no future benefits after December). These transactions also use up an asset (cash) in carrying out FastForward's operations. The accounting equation shows that both transactions reduce cash and equity. The far right column identifies these decreases as Expenses.
Transaction 8: Provide Services and Facilities for Credit FastForward provides consulting services of $1,600 and rents its test facilities for $300 to an amateur sports club. The rental involves allowing club members to try recommended footwear and accessories at FastForward's testing area. The sports club is billed for the $1,900 total. This transaction results in a new asset, called accounts receivable, from this client. It also yields an increase in equity from the two revenue components reflected in the Revenues column of the accounting equation:
Transaction 9: Receipt of Cash from Accounts Receivable The client in transaction 8 (the amateur sports club) pays $1,900 to FastForward 10 days after it is billed for consulting services. This transaction 9 does not change the total amount of assets and does not affect liabilities or equity. It converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was recognized when FastForward rendered the services in transaction 8, not when the cash is now collected. This emphasis on the earnings process instead of cash flows is a goal of the revenue recognition principle and yields useful information to users. The new balances follow: Point: Receipt of cash is not always a revenue.
Transaction 10: Payment of Accounts Payable FastForward pays CalTech Supply $900 cash as partial payment for its earlier $7,100 purchase of supplies (transaction 4), leaving $6,200 unpaid. The accounting equation shows that this transaction decreases FastForward's cash by $900 and decreases its liability to CalTech Supply by $900. Equity does not change. This event does not create an expense even though cash flows out of FastForward (instead the expense is recorded when FastForward derives the benefits from these supplies).
Transaction 11: Payment of Cash Dividend FastForward declares and pays a $200 cash dividend to its owner. Dividends (decreases in equity) are not reported as expenses because they are not part of the company's earnings process. Since dividends are not company expenses, they are not used in computing net income.
Summary of TransactionsWe summarize in Exhibit 1.9 the effects of these 11 transactions of FastForward using the accounting equation. First, we see that the accounting equation remains in balance after each transaction. Second, transactions can be analyzed by their effects on components of the accounting equation. For example, in transactions 2, 3, and 9, one asset increased while another asset decreased by equal amounts. Point: knowing how financial statements are prepared improves our analysis of them. we develop the skills for analysis of financial statements throughout the book. Chapter 13 focuses on financial statement analysis.
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