Learning Outcomes
By the end of this section, you will be able to:
- Assess the impact of business transactions on cash flow.
- Define double-entry accounting and explain how it supports the accounting equation.
How and when we record our transactions can have a significant impact on financial statements, especially the income statement (net income). In this section you will explore the impact business transactions have on financial statements under each method. In doing so, you’ll be introduced to double-entry accounting and see how it functions to support the accounting equation.
Timing of Business Activity versus Cash Flow
The first financial statement prepared is the income statement, a statement that shows the organization’s financial performance for a given period of time. We already saw that Chris, who is a sole proprietor, started a summer landscaping business on August 1, 2020. She categorized her business as a service entity and used the cash-basis method of accounting to record the initial operations for her business. Although Chris was using her family’s tractor to get her work done, she was responsible for paying for fuel and any maintenance costs. So, on August 31, Chris realized she had only $250 in her checking account.
This balance was lower than expected because she had spent only slightly less ($1,150 for brakes, fuel, and insurance) than she earned ($1,400)—leaving a net income of $250. While she would like the checking balance to grow each month, she realized that most of the August expenses were infrequent (brakes and insurance) and the insurance, in particular, was an unusually large expense. She knew that the checking account balance would likely grow more in September because she would earn money from some new customers; she also anticipated having fewer expenses.
This simple landscaping example can be used to discuss the elements of the income statement, which are revenues, expenses, gains, and losses for a particular period of time (see Figure 4.2). Together, these determine whether the organization has net income (where revenues and gains are greater than expenses and losses) or net loss (where expenses and losses are greater than revenues and gains). Revenues, expenses, gains, and losses are further defined in the Income Statement provided.
The income statement can also be visualized by the formula:
Let’s change this example slightly and assume the $1,000 payment to the insurance company will be paid in September rather than in August. In this case, the ending balance in Chris’s checking account would be $1,250, a result of earning $1,400 and only spending $100 for the brakes on the tractor and $50 for fuel. This stream of cash flows is an example of cash-basis accounting because it reflects when payments are received and made, not necessarily the time period that they affect. At the end of this section, you will address accrual accounting, which does reflect the time period that payments affect.
The Accounting Equation
It may be helpful to think of the accounting equation from a “sources and claims” perspective. Under this approach, the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated differently, every asset has a claim against it—by creditors and/or owners.
You may recall from mathematics courses that an equation must always be in balance. Therefore, we must ensure that the two sides of the accounting equation are always equal. We will explore the components of the accounting equation in more detail shortly. First, we need to examine several underlying concepts that form the foundation for the accounting equation: the double-entry accounting system, debits and credits, and the “normal” balance for each account that is part of a formal accounting system.
Think It Through
The Accounting Equation
On a sheet of paper, use three columns to create your own accounting equation. In the first column, list all the things you own (assets). List only the asset itself; don’t worry about any associated liabilities (expenses) in that column. In the second column, list any amounts owed (the liabilities). When you are done, total up all the assets. Then total up all the liabilities.
Now, use the accounting equation to calculate the net amount of the asset (equity). To do so, subtract the total assets from the total liabilities. This figure makes the accounting equation balance and represents equity, or an estimate of your net worth.
Here is something else to consider: Is it possible to have negative equity? It sure is . . . ask any college student who has taken out loans. At first glance there is no asset directly associated with the amount of the loan. But is that, in fact, the case? You might ask yourself why you should make an investment in a college education—what is the benefit (asset) to going to college? The answer lies in the difference in lifetime earnings with a college degree versus without a college degree. This is influenced by many things, including the supply and demand of jobs and employees. It is also influenced by the earnings for the type of college degree pursued.
Solution:
Answers will vary but may include vehicles, clothing, electronics (include cell phones and computer/gaming systems), and sports equipment. They may also include money owed on these assets, most likely vehicles and perhaps cell phones. In the case of a student loan, there may be a liability with no corresponding asset (yet). Responses should be able to evaluate the benefit of investing in college and the wage differential between earnings with and without a college degree.
Let’s continue our exploration of the accounting equation, focusing on the equity component in particular. Recall that we defined equity as the net worth of an organization. It is helpful to also think of net worth as the accounting value of the organization. Recall, too, that revenues (inflows as a result of providing goods and services) increase the accounting value of the organization. So every dollar of revenue an organization generates increases the overall value of the organization.
Likewise, expenses (outflows as a result of generating revenue) decrease the value of the organization. So each dollar of expenses an organization incurs decreases the overall value of the organization. The same approach can be taken with the other elements of the financial statements:
- Gains increase the value (equity) of the organization.
- Losses decrease the value (equity) of the organization.
- Investments by owners increase the value (equity) of the organization.
- Distributions to owners decrease the value (equity) of the organization.
- Changes in assets and liabilities can either increase or decrease the value (equity) of the organization depending on the net result of the transaction.
Let’s look at Chris’s Landscaping business again and do the same quick exercise you did with your personal finances. If we were to total all of Chris’s assets, we would find just one: $250 in cash. She’s using the family’s tractor, but she doesn’t own the tractor, so it is not her asset. Her liabilities are currently $0, as she paid cash for all the expenses she incurred already. If we total her assets, we get $250. Liabilities total $0. Using the accounting equation, we find her equity to currently be $250, or
Double-Entry Accounting
Accounting is based on a double-entry accounting system, which requires the following:
- Each time we record a transaction, we must record a change in at least two different accounts. Having two or more accounts change will allow us to keep the accounting equation in balance.
- Not only will at least two accounts change, but there must also be at least one debit and one credit side impacted.
- The sum of the debits must equal the sum of the credits for each transaction.
In order for companies to record the myriad of transactions they have each year, there is a need for a simple but detailed system. Journals are useful tools to meet this need.
Debits and Credits
Each account can be represented visually by splitting the account into left and right sides as shown. The graphic representation of a general ledger account is known as a T-account. It is called this because it looks like a “T,” as you can see with the T-account shown in Figure 4.3.
A debit records financial information on the left side of each account. A credit records financial information on the right side of an account. One side of each account will increase, and the other side will decrease. The ending account balance is found by calculating the difference between debits and credits for each account. You will often see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr, respectively. Depending on the account type, the sides that increase and decrease may vary. We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded equation (see Figure 4.4).
As we can see from this expanded accounting equation, Assets accounts increase on the debit side and decrease on the credit side. This is also true of Dividends and Expenses accounts. Liabilities increase on the credit side and decrease on the debit side. This is also true of Common Stock and Revenues accounts. This becomes easier to understand as you become familiar with the normal balance of an account.
The balance sheet is a reflection of the accounting equation (see Figure 4.5). It has two sections, assets in one section and liabilities and equity in the other section. It’s key to note that both assets and liabilities are broken down on the balance sheet into current and noncurrent classifications in order to provide more detail and transparency. Current assets are those that are consumed within a year. Assets that will be in use longer than a year are considered noncurrent. Current liabilities are those that will be due within a year. Noncurrent liabilities are those that are due more than a year into the future.
Notice each account subcategory (Current Assets and Noncurrent Assets, for example) has an “increase” side and a “decrease” side. As you may recall, these are called T-accounts, and they are used to analyze transactions.
The basic components of even the simplest accounting system are accounts and a general ledger. An account is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation. Each of these categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger. A general ledger is a comprehensive listing of all of a company’s accounts with their individual balances.