Chapter Two: Analyzing Transactions: The Accounting Equation

CHAPTER TWO
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
Left side:
Assets
ACCOUNTING EQUATION
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 M. A.
CAPITAL
ASSET OWNER’S
EQUITY
QUESTION #3a
Determine whether the accounts
have increased or decreased
CASH M. A.
CAPITAL
INCREASED INCREASED
QUESTION #3b
Does accounting equation balance?
ASSETS = LIABILITIES + OWNER’S EQUITY

CASH = M. A.,CAPITAL
+$25,000 = +$25,000
It Balances!
Assets of $25,000 = Liab. of $0
plus Owner’s Equity of $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 CASH
SUPPLIES
ASSET ASSET
INCREASED DECREASED
QUESTION #3b
Let’s look at the accounting equation
ASSETS = LIAB. + O. E.
CASH + OFF. SUPPLIES =
-$800 + +$800 =
Right hand side
of equation is
not affected
QUESTION #3b
Does transaction balance?
CASH + OFF. SUPPLIES =
-$800 + +$800 =
Yes!
Total Assets stayed the same.
One Asset increased, the other
decreased. No change in
Liabilities or Owner’s Equity
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 OWNER’S EQUITY
BALANCE $0 $25,000
BALANCE $0 $25,000
RIGHT SIDE OF EQUATION:
LIABILITIES $ 0
OWNER’S EQUITY $25,000
TOTAL LIAB. & O.E. $25,000
EXAMPLE
PURCHASED EQUIPMENT ON
ACCOUNT FOR $3,000
QUESTIONS #1 & #2
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
accounts
EQUIP. ACCOUNTS
PAYABLE
ASSET LIABILITY
QUESTION #3a
EQUIP. ACCOUNTS
PAYABLE
ASSET LIABILITY
INCREASED INCREASED
QUESTION #3b
Let’s look at the accounting equation:

EQUIP. = ACCOUNTS
PAYABLE
+ $3,000 = + $3,000 This transaction had
no effect on
Owner’s Equity
QUESTION #3b

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:
ACCTS. PAY. M. A., CAPITAL
+$25,000
BAL. $25,000
+$3,000
BAL. $3,000 $25,000
$3,000 + $25,000 =$28,000

TOTAL LIAB. & O. E.
EXAMPLE
MADE $400 PAYMENT ON EQUIPMENT
QUESTIONS #1 & #2
accounts
CASH ACCOUNTS
PAYABLE
ASSET LIABILITY
QUESTION #3a
CASH ACCOUNTS
PAYABLE
ASSET LIABILITY
DECREASED DECREASED
QUESTION #3b
Let’s look at the accounting equation:

CASH = ACCOUNTS
PAYABLE
- $400 = - $400 This transaction had
no effect on
Owner’s Equity
QUESTION #3b

CASH = ACCOUNTS
PAYABLE
- $400 = - $400
It Balances!
Assets decreased by $400 =
Liab. decreased by $400
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
CASH SUPPLIES EQUIPMENT
$25,000
- $800 $800
BAL. $24,200 $800
+$3,000
BAL. $24,200 $800 $3,000
-$400
BAL. $23,800SUPPLIES
$800 $3,000
$27,600
PROVING ACCOUNTING
EQUATION BALANCES:
ACCTS. PAY. M. A., CAPITAL
+$25,000
BAL. $25,000
+$3,000
BAL. $3,000 $25,000
-$400
BAL. $2,600 $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 = NET INCOME

$6,000 $5,000 = $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 = NET LOSS

$8,000 $9,500 = ($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
accounts
CONSULT. CASH
FEES
O.E. ASSET
REVENUE
QUESTION #3a
CONSULT. CASH
FEES
INCREASE INCREASE
QUESTION #3b
ASSETS = LIAB. + OWNER’S EQUITY

CASH = CONSULT.
FEES
+$4,500 = +$4,500
It Balances!
Owner’s Equity increased by $4,500
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
BAL. $23,800 $800 $3,000
+ $4,500
BAL. $28,300 $800 $3,000
$32,100
PROVING ACCOUNTING
EQUATION BALANCES:
LIAB. OWNER’S EQUITY
ACCTS. M. A., CONSULT.
PAY. CAPITAL FEES
BAL. $2,600 $25,000
+ $4,500
BAL. $2,600 $25,000 $4,500
$32,100
EXPENSE EXAMPLE
MARY ADAMS PAID HER

ASSISTANT $750 IN WAGES
QUESTIONS #1 & #2
accounts
WAGES CASH
EXPENSE
O.E. ASSET
EXPENSE
QUESTION #3
WAGES CASH
EXPENSE
INCREASE DECREASE
QUESTION #3
WAGES CASH
EXPENSE
BE CAREFUL! While incurring an
expense will increase the Expense account,
it will cause an overall
DECREASE IN OWNER’S EQUITY
QUESTION #3b

CASH = WAGES
EXPENSE
- $750 = +$750
It Balances!
Assets decreased by $750 =
Owner’s Equity decreased by $750
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
BAL. $28,300 $800 $3,000
- $750
BAL. $27,550 $800 $3,000
$31,350
PROVING ACCOUNTING
EQUATION BALANCES:
ACCTS. M. A., REV. EXPENSES
PAY. CAPITAL
BAL. $2,600 $25,000 $4,500
+ $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
CONSULT. ACCOUNTS
FEES RECEIVABLE
O.E. ASSET
REVENUE
QUESTION #3a
CONSULT. ACCOUNTS
FEES RECEIVABLE
INCREASE INCREASE
QUESTION #3b

ACCTS. = CONSULT.
RECEIVABLE FEES
+$6,000 = +$6,000
It Balances!
Owner’s Equity increased by $6,000
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
CASH ACCTS. SUPPLIES EQUIP.
REC.
BAL. $27,550 $800 $3,000
+ $6,000
BAL. $27,550 $6,000 $800 $3,000
$37,350
PROVING ACCOUNTING
EQUATION BALANCES:
PAY. CAPITAL
BAL. $2,600 $25,000 $4,500 $750
+ $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
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
CASH ACCOUNTS
RECEIVABLE
ASSET ASSET
QUESTION #3a
CASH ACCOUNTS
RECEIVABLE
INCREASE DECREASE
QUESTION #3b
CASH ACCTS. REC. =
+$2,500 -$2,500 =
Yes!
Total Assets stayed the same.
One Asset increased, the other
decreased. No change in
Liabilities or Owner’s Equity
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
REC.
BAL. $27,550 $6,000 $800 $3,000
+$2,500 -$2,500
BAL. $30,050 $3,500 $800 $3,000
$37,350
PROVING ACCOUNTING
EQUATION BALANCES:
PAY. CAPITAL
BAL. $2,600 $25,000 $10,500 $750
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
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
accounts
M. A., CASH
DRAWING
O.E. ASSET
DRAWING
QUESTION #3a
M. A., CASH
DRAWING
INCREASE DECREASE
QUESTION #3a
M. A., CASH
DRAWING
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

CASH = M.A.,
DRAWING
-$1,500 = +$1,500
It Balances!
Assets decreased by $1,500 =
Owner’s Eq. decreased by $1,500
PROVING ACCOUNTING
EQUATION BALANCES:
ASSETS:
REC.
BAL. $30,050 $3,500 $800 $3,000
-$1,500
BAL. $28,550 $3,500 $800 $3,000
$35,850
PROVING ACCOUNTING
EQUATION BALANCES:
ACCTS. M. A., M. A., REV. EXP.
PAY. CAP. DRAWING
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
Income Statement
This column is used

for listing items
to be totaled
Income Statement
This column is used

for Totals
Income Statement
Revenues:
Consulting Fees $2,150
First item at the top of

a column should include
“$”
Income Statement
Revenues:
Expenses:
Wages Expense $ 650
Rent Expense 200
Telephone Expense 50
Total Expenses 900
Underline before totaling

Income Statement
Revenues:
Expenses:
Wages Expense $ 650
Rent Expense 200
Total Expenses 900
Net Income $1,250
Revenues are greater than Expenses,

therefore total is called NET INCOME
Income Statement
Revenues:
Expenses:
Wages Expense $ 650
Rent Expense 200
Total Expenses 900
Net Income $1,250
Double underline
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
Statement of Owner’s Equity
Jessica Jane, capital, June 1, 20-- $2,000

Net Income for June $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.

Less withdrawal for June 150
Increase in Capital 1,100
$1,250 Net Income - $150 Withdrawal =

$1,100 increase in Capital

Less withdrawal for June 150
Increase in Capital 1,100
$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
Balance Sheet
June 30, 20--
Balance Sheet reports Assets,

Liabilities and Owner’s Equity
on a SPECIFIC DATE,
Not a period of time
Balance Sheet
June 30, 20--
Assets Liabilities
Cash $ 370 Accounts Payable $1,800
Accounts Receivable 650
Supplies 80 Owner’s Equity
Prepaid Insurance 200 Jessica Jane, Capital 3,100
Delivery Equipment 3,600
Total Liabilities and
Total Assets $4,900 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 OF
STATEMENT OWNER’S EQUITY
REVENUES BEGINNING CAPITAL
minus plus
INVESTMENTS
EXPENSES plus
equals NET INCOME
minus
NET INCOME WITHDRAWALS
equals
ENDING CAPITAL
OUTPUT
BALANCE SHEET
ASSETS
equal
LIABILITES
plus
OWNER’S EQUITY
(Ending Capital)

Chapter Two: Analyzing Transactions: The Accounting Equation

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Chapter Two: Analyzing Transactions: The Accounting Equation

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CHAPTER TWO

ITEMS OWNED BY A BUSINESS THAT

ITEMS OWNED BY A BUSINESS THAT

BUT DOESN’T HAVE

PROBABLE FUTURE OUTFLOW OF

Be careful!! Don’t confuse Accounts

AMOUNT BY WHICH THE BUSINESS

Once the debts are paid,

Right side shows where

A separate record used to summarize

Make certain you understand the

WHICH ACCOUNTS ARE

HOW IS THE ACCOUNTING

Mary took $25,000 from her

ASSETS = LIABILITIES + OWNER’S EQUITY

ASSETS = LIABILITIES + OWNER’S EQUITY

ASSETS = LIABILITIES + OWNER’S EQUITY

$3,000 + $25,000 =$28,000

ASSETS = LIABILITIES + OWNER’S EQUITY

ASSETS = LIABILITIES + OWNER’S EQUITY

 Rent  Supplies Consumed

REVENUE Greater than EXPENSES = NET INCOME

REVENUE EXPENSES = NET INCOME

EXPENSES Greater than REVENUE = NET LOSS

REVENUE EXPENSES = NET LOSS

 The owner taking (withdrawing) cash or

ASSETS = LIAB. + OWNER’S EQUITY

MARY ADAMS PAID HER

ASSETS = LIAB. + OWNER’S EQUITY

$2,600 + $25,000 + $4,500 $750 =

Mary has performed services for this

ASSETS = LIAB. + OWNER’S EQUITY

$2,600 + $25,000 + $10,500 $750

When Mary provided the consulting

No Change to Right Side of Equation.

Mary is withdrawing some of her

BE CAREFUL! Just like Expenses,

ASSETS = LIAB. + OWNER’S EQUITY

$2,600 + $25,000 - $1,500 + $10,500 -$750

THREE COMMONLY PREPARED

Financial Statement headings:

This column is used

This column is used

First item at the top of

Underline before totaling

Revenues are greater than Expenses,

Reports the activities that affected

Jessica Jane, capital, June 1, 20-- $2,000

Instead of showing Revenue increasing &

Jessica Jane, capital, June 1, 20-- $2,000

$1,250 Net Income - $150 Withdrawal =

Jessica Jane, capital, June 1, 20-- $2,000

$2,000 beginning O. E. + $1,100 increase =

Balance Sheet reports Assets,

THREE BASIC PHASES:

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