Measuring Business Activities:
Measuring external transactions (financial accounting) is accomplished by a basic 6 step process (see Illustrations 2-1).
- Use source documents (sales invoices, bills from suppliers, signed contracts)
- Use the Accounting Equation to determine the financial impact
- Determine whether each transaction is a Debit or Credit
- Record Debit or Credits in Journal
- Post the transaction to the General Ledger
- Prepare a Trial Balance
Asset Accounts include: Cash, Supplies, and Equipment. All transactions affecting Cash are summarized in the Cash Account.
There are generally many types of Accounts, such as: Accounts Payable, Salary Payable, Utilities Payable, and Taxes Payable.
Stockholder Equity Accounts include: Common Stock and Retained Earnings
A list of all accounts names used to record transactions of a company are referred to as Chart of Accounts.
Effects of Transactions on the Basic Accounting Equation
We now begin to understand how certain business activities can affect the different variables for the Basic Accounting Equation, A = L + SE
The left side (Assets) and the Right side (Liabilities + Stockholder Equity) must remain in Balance. If not, then check your data for corrections.
Assets = Cash, Supplies, and Equipment
When a company takes out a loan, the company will generally consider it cash, unless the loan is specific for a particular equipment. When designating the loan as cash, the cash assets rise, but so does the Liabilities, because the money is a loan that the company must repay. (For the purpose of this section, we will disregard the interest rates that would affect the total value of the Liabilities, but we will just quickly discuss the affects of additional interest rates for illustration).
Say, Company A takes a loan for $100,000 as cash. The reporting would list the loan as a $100,000 Cash Asset and $100,000 Liability. But in reality, the loan is affected by monthly interests rates. If we include the interest rates then the liabilities would be greater than the cash received. Think about that fact. If the interest rate was simple, at 5% then the liability would be $5000 greater the following month. The interest would be reported in the Notes Payable from the Liabilities category.
When a company uses cash to buy equipment, their Assets values to no alter, only which sub class of assets, from a decrease in cash to an increase in equipment.
Types of Liability Accounts: Accounts Payable, Salaries Payable, Utilities Payable, Notes Payable and Taxes Payable. These are accounts where the company owes money to an person or entity.
Stockholder Equity Accounts include Common Stock and Retained Earnings
Common Stock is sold to investors in order to raise cash for the company. So when a company sells stock it is increasing both the cash and the total number of stockholders, so both sides of the equation increases.
Business Transactions that Occur in the Future:
A business can purchase for services in advance of receiving the benefit, such as rent, insurance, advertising, when that company has prepaid for these services in full. Make sure that you determine whether a service is prepaid or paid over installments.
Because prepaid services are reported as a company asset and not as a liability, because it is considered a future resource for the company.
A similar situation can arise when a customer prepays for services. The service has not been realized, so it is not reported as revenue , but as a Deferred Revenue. But is also common for a customer to promise to pay for services, which would be reported under Accounts Receivable.
Moment for Thought! If a customer gives verbal commitment to pay, but never secures the service or goods, is the customer still required to pay? How would you report this is a customer ultimately promise to pay for services/goods but never receives it and thus never pays for it?
Remember that Dividends do reduce Retained Earnings but they are not reported as Expenses. Always report from the perspective of the company and not the stockholders.
Debits and Credits
This is the area of knowledge that confuses so many students, because the use of these terms can be counterintuitive.
Try and Think of Debits and Credits as merely the Left (Debits) and Right (Credits) side of the ledger, not whether something is a increase or decrease. Please review Illustration 2-5 Debits and Credits and Illustration 2-6
This is where the terms cause confusion. When cash is added to an Cash Account the Left side (Debits) Increases, while when Cash is spent the Right (Credits) decreases.
Review Illustration 2-7 and review how the acronym DEALOR is utilized. This acronym is to help reduce the confusion that Illustration 2-5 reveals, by the fact that Debits (Left) and Credits (Right) can sometimes be considered both a increase/decrease for different components of the Basic Accounting Equation A = L + SE
In the Assets Categories: Increases are Debits and Decreases are Credits; but that is inverted with Liabilities and Stockholder Equity: Decreases are Debits and Increases are Credits
