CHAPTER 2

ACCOUNTING EQUATION
AND TRANSACTION ANALYSIS

Accounting Principle
 Learning Objectives

LO1. Balance sheet DO IT! 1.4

Describe the components of The Basis Accounting Equation The
the financial statements and Income statement accounting
explain the accounting The Expanded Accounting equation
equation Equation
LO2. If an asset is increase, there must DO IT! 1.5
Analyze the effects of be a corresponding: Transaction
business transactions on the 1. Decrease in another asset, or analysis
accounting equation. 2. Increase in a liabilities, or
3. Increase in owner’s equity
LO3. Income statement DO IT! 1.6
Prepare financial statements Statement of owner’s equity
Balance sheet, and
Cash flow statement
 L01. Accounting Model

Claims on the economic resources are Users need information on the economic
the amounts owed by the business and resource that the business can use to carry
the owner’s rights to the resources. In out its business activities to earn a profit
accounting, amounts owed by the and the claims to these economic
business are called “liabilities” and the resources. In accounting, economic
owner’s right to these resources is called resources that are owned or controlled by
“Owner’s equity” a business are called “assets”
 The Accounting Equation

The relationship between assets, liabilities, and owner’s equity is expressed as an equation,
called the accounting equation.
Assets must equal the sum of liabilities and owner’s equity
Liabilities are shown before owner’s equity in the accounting equation because creditors
have the right to receive payment before owners.

The Basis Accounting Equation

Assets = Liabilities + Owner’s Equity

 Balance sheet/ Statement of financial position

Liabilities
Assest: Present obligations to transfer an economic
Present economic resources resource.
controlled by the business Ex. Accounts payable, salaries payable
that have the potential to
produce economic benefits. +
Ex. Accounts receivable, Owner’s equity
merchandise inventory, The owner’s claim on the assets
vehicles… Ex. Residual amount of assets minus liabilities

=> This is the components in the balance sheet

 Brief Exercises

BE1-1 Presented below is the basic accounting equation. Determine the

missing amounts.

Case Assets Liabilities Owner’s Equity

1. $90,000 $50,000 ?
2. ? $40,000 $70,000
3. $94,000 ? $53,000
 Brief Exercises

BE1-2 Given the accounting equation, answer each of the following questions.
(a) The liabilities of Buerhle Company are $120,000 and the owner’s equity is
$232,000. What is the amount of Buerhle Company’s total assets?

(b) The total assets of Buerhle Company are $190,000 and its owner’s equity is
$91,000. What is the amount of its total liabilities?

(c) The total assets of Buerhle Company are $800,000 and its liabilities are
equal to one-half of its total assets. What is the amount of Buerhle Company’s
owner’s equity
 Brief Exercises

BE1-3 At the beginning of the year, Danks Company had total assets of
$800,000 and total liabilities of $300,000. Answer the following questions.

(a) If total assets increased $150,000 during the year and total liabilities
decreased $80,000, what is the amount of owner’s equity at the end of the
year?

(b) During the year, total liabilities increased $100,000 and owner’s equity
decreased $70,000. What is the amount of total assets at the end of the year?

(c) If total assets decreased $80,000 and owner’s equity increased $120,000
during the year, what is the amount of total liabilities at the end of the year?
 The Expanded Accounting Equation

The basic accounting equation shows that assets are equal to liabilities plus owner’s equity.
But we also know that it is necessary to report on revenues, expenses, and other changes in
owner’s equity. We have expanded the basic accounting equation to show the different parts
of owner’s equity and the relationship between revenues, expenses, profit (or loss), and
owner’s equity.
Balance sheet

Assets = Liabilities + Owner’s Equity

Owner’s capital - Drawings + Profit (or loss) - dividends

(Investments)
Revenues - expenses
Income statement
 The Expanded Accounting Equation

Income statement

Revenues:
Revenues result from business activities that are undertaken to earn profit, such as
performing services, selling merchandise inventory, renting property, and lending money.

an increase in an asset
to keep the
Revenues result in an increase in owner’s equity equation
balanced
a decrease in liabilities
 The Expanded Accounting Equation

Income statement
Expenses
Expenses are the costs of assets that are consumed and services that are used in a company’s
business activities.
decrease in assets

increases in liabilities to keep the

Expenses are equation
balanced
result in a decrease in
owner’s equity
 The Expanded Accounting Equation

Income statement

Profit
Profit describes the financial benefit realized when revenue generated from a business
activity exceeds the expense cost and tax involved in sustaining the activity in question.
Profit is calculated as total revenue less total expenses.

Profit (loss) = Total revenues - Total expenses

 DO IT 1.4 The Accounting Equation

The following are a few of the items that are reported in financial statements:
1. Cash
2. Service revenue
3. Drawings
4. Accounts receivable
5. Accounts payable
6. Salaries expenses

a. Classify the items assets, liabilities, or owner’s equity. For the owner’s equity
items, indicate whether these items increase or decrease equity.

a. Indicate which financial statement the item is reported in.

 DO IT 1.4 The Accounting Equation

Solution
Items Type of item Financial Statement

1. Cash Assets Balance sheet

2. Service revenue Owner’s equity - increase Income statement

3. Drawings Owner’s equity -decrease Statement of Owner’s

equity
4. Accounts receivable Assets Balance sheet

5. Accounts payable Liabilities Balance sheet

6. Salaries expenses Owner’s equity-decrease Income statement

 Brief Exercises

BE1-4 Use the expanded accounting equation to answer each of the

following questions.
(a) The liabilities of Falk Company are $90,000. Owner’s capital account is
$150,000; drawings are $40,000; revenues, $450,000; and expenses,
$320,000. What is the amount of Falk Company’s total assets?

(b) The total assets of Pierogi Company are $57,000. Owner’s capital
account is $25,000; drawings are $7,000; revenues, $52,000; and
expenses, $35,000. What is the amount of the company’s total liabilities?

(c) The total assets of Yanko Co. are $600,000 and its liabilities are equal to
two-thirds of its total assets. What is the amount of Yanko Co.’s owner’s
equity?
 LO2. Transaction Analysis

Once it has been determined that an event or transaction should be recognized, it must be
analyzed for its effect on the components of the accounting equation before it can be
recorded. This analysis must identify the specific items that are affected and the amount of
change in each item.

Each transaction must have a dual effect on the equation for the two sides of the accounting
equation to remain equal.

Ex. An asset (equipment) could increase by $10,000, a different asset (cash) decrease by
$6,000, and a liability (notes payable) could increase by $4,000.
 Brief Exercises

BE1-7 Follow the same format as BE1-6 on the previous page. Determine the
effect on assets, liabilities, and owner’s equity of the following three
transactions.
(a) Invested cash in the business.
(b) Withdrawal of cash by owner.
(c) Received cash from a customer who had previously been billed for
services provided.
 Transaction 1: Investment by Owner

Andrew Leonid decides to open a computer programming business, which he names

Softbyte. On September 1, 202X, he invests $15,000 cash in the business, which he deposited
in a bank account opened under the name of Softbyte. This transaction results in an equal
increase in both assets and owner’s equity for Softbyte, as shown in Illustration 1.13

Basic Analysis The asset Cash is increased by $15,000, and the owner’s equity
account, A.Leonid, capital, is increased by $15,000
Assets = Liabilities + Owner’s Equity
Equation Analysis Cash = A.Leonid,Capital
+ $15,000 = $ 15,000
(Tr1)
Illustration 1.13. Investment of cash by owner
 Transaction 2: Purchase of equipment for cash

Softbyte purchases computer equipment for $7,000 cash. This transaction result in an equal
increase and decreased in total assets, though the composition of the asset changes. The
specific effect of this transaction and the cumulative effect of the first two transactions are
demonstrated in Illutration 1.14
Basic Analysis The asset Cash is decreased by $7,000, and the asset Equipment is
increased by $7,000
Assets = Liabilities + Owner’s Equity
Equation Analysis Cash + Equipment = A.Leonid,Capital
Old Balance + $15,000 = $ 15,000
(Tr2) -$7,000 +$7.000
New Balance +$8,000 + $7,000 = $15,000
$15,000 $15,000
Illustration 1.14. Investment of cash by owner
 Transaction 3: Purchase of Supplies on Credit

Softbyte purchases $1,600 of computer paper and other supplies that are expected to last
several months from the Alpha Supply Company. Alpha Supply will allow Softbyte to pay
this bill next month (in October). This transaction is referred to as a purchase on account, or
credit purchase. Assest are increased because the use of the paper and supplies is capale of
producing economic benefits. Liabilities are increased by the amount that is due to Alpha
Supply Company.
Basic Analysis The asset Cash is decreased by $7,000, and the asset Equipment is increased by $7,000
Assets = Liabilities + Owner’s Equity
Equation Analysis Cash + Supplies + Equipment = Accounts payable A.Leonid,Capital
Old Balance + $8,000 $7,000 = $ 15,000
(T3) + $1,600 $1,600
New Balance +$8,000 + $1,600 + $7,000 = $1,600 + $15,000
$16,600 = $16,600

Illustration 1.15. Purchase of supplies on credit

 Transaction 4: Services provided for Cash

Softbyte receives $1,200 cash from customers for programming services it has provided. This
transaction is Softbyte’s main revenue-producing activity. Remember that revenue increases
profit, which then increases owner’s equity.

Basic Analysis The asset Cash is increased by $1,200, and the the owner’s equity account Sevices Revenue is
increased by $1,200
Assets = Liabilities + Owner’s Equity
Equation Analysis Cash + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues
Old Balance +$8,000+$1,600 + $7,000 = $1,600 + $15,000
(Tr4) + $1,200 $1,200
New Balance +$9,200 + $1,600 + $7,000 = $1,600 + $15,000 + $1,200
$17,800 = $17,800

Illustration 1.16. Services provided for cash

 Transaction 5: Purchase of Advertising on Credit

Softbyte receives a bill for $250 from the local newspaper for advertising the opening of its
business. It postpones payment of the bill until a later date. The cost of advertising is an
expense, and not an asset, because the benefits have already been used. Owner’s equity
decrease because an expense is incurred. Expenses reduce profit and owner’s equity.
Basic Analysis The liabilities Accounts Payable is increased by $250 and the owner’s equity account Advertising Expensive is
increased by $250
Assets = Liabilities + Owner’s Equity
Equation Analysis Cash + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues - expenses
Old Balance +$9,200+$1,600 + $7,000 = $1,600 + $15,000
(Tr5) + $250 - $250
New Balance +$9,200 + $1,600 + $7,000 = $1,850 + $15,000 + $1,200 - $250
$17,800 = $17,800

Illustration 1.17. Purchase of Advertising on Credit

 Transaction 6: Services provided for cash and credit

Softbyte provides $3,500 of programming services for customers. Cash of $1,500 is received
from the customers, and the banlance $2,000 is billed to customers on account. This
transaction result in an equal in crease in asset and owner’s equity.
Basic Analysis The liabilities Accounts Payable is increased by $250 and the owner’s equity account Advertising
Expensive is increased by $250
Assets = Liabilities + Owner’s Equity
Equation Analysis Cash + Account Receivable + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues - expenses
Old Balance +$9,200 + $1,600 + $7,000 = $1,850 + $15,000 + $1,200 - $250
(Tr6) +$1,500 + $2,000 + $3,500
New Balance +$10,700 + $2,000 + $1,600 + $7,000 = $1,850 + $15,000 + $4,700 - $250
$21,300 = $21,300

Illustration 1.18. Services provided for cash

 Transaction 7: Payment of expense

The expenses paid in cash for September are store rent $600, salaries of employees $900, and
Utilities $200. These payments result in an equal decrease in assets and owner’s equity.
Basic Analysis The liabilities Accounts Payable is increased by $250 and the owner’s equity account Advertising Expensive is increased by
$250
Assets = Liabilities + Owner’s Equity

Equation Analysis Cash + Account Receivable + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues - expenses

Old Balance +$10,700 + $2,000 + $1,600 + $7,000 = $1,850 + $15,000 + $4,700 - $250

(Tr7) -$600 - $600

-$900 - $900
-$200 - $200
New Balance +$9,000 + $2,000 + $1,600 + $7,000 = $1,850 + $15,000 + $4,700 - $1,950

$19,600 = $19,600

Illustration 1.19. Payment of expense

 Transaction 8: Payment of account payable

Softbyte pays its $250 advertising bill in cash. Remember that the bill was previously
recorded in transaction (5) as an increase in Account payable, and decrease in owner’s equity.

Basic Analysis The liabilities Accounts Payable is increased by $250 and the owner’s equity account Advertising Expensive is increased by
$250
Assets = Liabilities + Owner’s Equity

Equation Analysis Cash + Account Receivable + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues - expenses

Old Balance +$9,000 + $2,000 + $1,600 + $7,000 = $1,850 + $15,000 + $4,700 - $1,950

(Tr8) -$250 - $250

New Balance +$8,750 + $2,000 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950

$19,350 = $19,350

Illustration 1.20. Payment of account payable

 Transaction 9: Receipt of cash on account

The sum of $600 in cash is received from some customers who were billed for services in
transaction(6). This transaction does not change total asset, but it does change in composition
of those assets.
Basic Analysis The liabilities Accounts Payable is increased by $250 and the owner’s equity account Advertising Expensive is increased by
$250
Assets = Liabilities + Owner’s Equity

Equation Analysis Cash + Account Receivable + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues - expenses

Old Balance +$8,750 + $2,000 + $1,600 + $7,000 = $1,850 + $15,000 + $4,700 - $1,950

(Tr9) +$600 - $600

New Balance +$9,350 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950

$19,350 = $19,350

Illustration 1.21. Receipt of cash on account

 Transaction 10: Signed contract to rent equipment in October

Andrew Leonid and an equipment supplier sign a contract for Softbyte to rent equipment for
the months of October and November at the rate of $250 per month. Softbyte is to pay each
month’s rent at the start of the month. There are no effect on the accounting equation because
the assets, liabilities and owner’s equity have not been changed by the signing of the contract.
An accounting transaction has not occurred. At this point, Softbyte has not paid for anything,
nor has it used the equipment, and therefore it has not incurred any expenses.
Basic Analysis The liabilities Accounts Payable is increased by $250 and the owner’s equity account Advertising Expensive is increased by
$250
Assets = Liabilities + Owner’s Equity

Equation Analysis Cash + Account Receivable + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues - expenses

Old Balance +$9,350 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950

(Tr10) No entry

New Balance +$9,350 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950

$19,350 = $19,350

Illustration 1.22. Signed contract to rent equipment in October

 Transaction 11: Withdrawal of cash by Owner

Andrew Leonid withdraws $1,300 in cash from the business for his personal use. This
transaction results in an equal decrease in an asset, and owner’s equity.

Basic Analysis The liabilities Accounts Payable is increased by $250 and the owner’s equity account Advertising Expensive is increased by
$250
Assets = Liabilities + Owner’s Equity

Equation Analysis Cash + Account Receivable + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues - expenses

Old Balance +$9,350 + $1,400 + $1,600 + $7,000 = $1,600 + $15,000 + $4,700 - $1,950

(Tr11) - $1,300 - $1,300

New Balance +$8,050 + $1,400 + $1,600 + $7,000 = $1,600 + $13,700 + $4,700 - $1,950

$18,050 = $18,050

Illustration 1.23. Withdrawal of cash by Owner

 Summary of transactions
Illustration 1.24. Tabular summary of Softbyte transactions
Tr Accounting Aquation

Assets = Liabilities + Owner’s Equity

Cash + Account Receivable + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues – expenses

1 +$15,000 + $15,000

2 - $7,000 + $7,000

3 +$1,600 +$1,600

4 + $1,200 + $1,200

5 +$250 -$250

6 +$1,500 +$2,000 + $3,500

7 -$1,700 -$1,700

8 -$250 -$250

9 +$600 -$600

10 No Entry

11 -$1,300 -$1,300

Sum $8,050 + $1,400 + $1,600 + $7,000 $1,600 + $13.700 + $ 4,700 - $ 1,950

Sum $ 18,050 = $ 18,050

 Summary of transactions

Softbyte’s transactions are summarized in Illustration 1.24 to show their cumulative effect on
the accounting equation. The transaction number and the specific effects of each transaction
are indicated.

Illustration demonstrates some significant facts:

➢ Each transaction must be analyzed for its effects on:
▪ The three components (assets, liabilities, and owner’s equity) of the accounting equation,
and
▪ Specific items within each component.
➢ The two sides of the equation must always be equal.
 DO IT 1.5 Tabular Analysis

Transactions for the month of August by Dawd & Co., a public accounting firm, are shown
below. Make a table that shows the effect of these transactions on the accounting equation,
like the tabular analysis shown in Illustration 1.24.
1. The owner, John Dawd, invested $25,000 of cash in the business.
2. Equipment was purchase on credit, $7,000.
3. Services were performed for customers for $8,000. Of this amount, $2,000 was received
in cash and $6,000 is due on account.
4. Rent of $850 was paid for the month.
5. Customers on account paid $4,000 (see transaction 3).
6. The owner withdrew $1,000 of cash for personal use.
 Summary of transactions

Tr Accounting equation

Assets = Liabilities + Owner’s Equity

Cash + Account Receivable + Equipment = Accounts payable + J. Dawd,Capital + revenues – expenses

1 +$25,000 + $25,000

2 + $7,000 + $7,000

3 +$2,000 +$6,000 +$8,000

4 - $850 - $850

5 + $4,000 -$4,000

6 -$1,000 -$1,000

Sum $29,150 + $2,000 + + $7,000 = $7,000 + $ 24,000 + $ 8,000 - $850

Sum $ 38,150 = $ 38,150

Illustration 1.25. Tabular summary of Dawd’s transactions

 Brief Exercises
BE1-6 Presented below are three business transactions. On a sheet of paper, list the letters
(a), (b), and (c) with columns for assets, liabilities, and owner’s equity. For each column,
indicate whether the transactions increased (1), decreased (2), or had no effect (NE) on
assets, liabilities, and owner’s equity.
(a) Purchased supplies on account.
(b) Received cash for providing a service.
(c) Paid expenses in cash.
 LO3. Prepare Financial Statements

Income statement

Statement of owner’s equity

Financial Statements Balance sheet, and

Cash flow statement

Explanatory statement
 LO3. Prepare Financial Statements
DO IT! 1.6
LO3. Prepare Financial Statements
 LO3. Prepare Financial Statements
Joan Robinson, Attorney
Income Statement
Month Ended July 31, 202X
Details Total
Revenues $3,500
Service revenue
Expenses
Rent expense $800
Salaries and wages expense $500
Utilities expense $300
Supplies expense $100
Total expenses $1,700
Net income $1,800
 LO3. Prepare Financial Statements
Joan Robinson, Attorney
Statement of Owner’s Equity
Month Ended July 31, 202X
Details Total
Owner’s equity, July 1 $0
Add: Investments $11,000
Net income $1,800 $12,800
Less: Drawings $1,000 $1,000
Owner’s equity, July 31 $11,800
 LO3. Prepare Financial Statements
Joan Robinson, Attorney
Balance Sheet
July 31, 202X
Assets
Cash $10,500
Accounts receivable $2,000
Equipment $3,000
Total assets $15,500
Liabilities and Owner’s Equity
Liabilities $3,700
Notes payable $ 700
Accounts payable $3,000
Owner’s equity $11,800
Owner’s equity, July 31 $11,800
Total liabilities and owner’s equity $15,500
 Brief Exercises

BE1-10 In alphabetical order below are balance sheet items for George Company at
December 31, 2012. Kayla George is the owner of George Company. Prepare a
balance sheet, following the format of Illustration 1-9.

Accounts receivable $72,500

Cash $49,000
Owner’s capital $31,500
Accounts payable $90,000
 Brief Exercises
BE1-11 Indicate whether the following items would appear on the
income statement (IS), balance sheet (BS), or owner’s equity statement
(OE).

_______ (a) Notes payable

_______(d) Cash
_______ (b) Advertising expense
_______(e) Service revenue
_______ (c) Owner’s capital
BE1-12 Presented below is selected information related to Lance Company at December
31, 202X. Lance reports financial information monthly.
(a) Determine the total assets of Lance Company at December 31, 2012.
(b) Determine the net income that Lance Company reported for December 2012.
(c) Determine the owner’s equity of Lance Company at December 31, 2012.

Accounts Payable $ 3,000 Salaries and Wages Expense $16,500

Cash 4,500 Notes Payable 25,000
Advertising Expense 6,000 Rent Expense 10,500
Service Revenue 51,500 Accounts Receivable 13,500
Equipment 29,000 Owner’s Drawings 7,500
 Thank you for your listening!

QUESTION AND ANSWER