Chapter 8



Chapter 8 Name_________________________________

Financial Accounting Date__________________ Score___________

Have you ever wondered how a rap group or a rock band determines what cities their tours will play? What determines the price of tickets, and how much does a national tour cost? These questions are all examined by professional teams made up of accountants and financial advisers.

Accounting plays a vital role in the day-to-day activities of your business – and of every business. Accounting records and reports help your business operate efficiently – and profitably – by keeping track of how much is earned and how much is spent. Accounting is so much a part of the business world that it is often called “the language of business.”

The Accounting System

Whether you’re keeping financial records for a rock band, a neighborhood bike shop, or a major corporation, accounting principles and procedures are universal. All businesses use the same system, which follows established accounting guidelines called “generally accepted accounting principles,” or GAAP (pronounced gap). With all businesses using the same system, anyone who is interested in examining the records of a business will be able to understand its financial reports.

The accounting system is designed to collect, record, and report on financial transactions that affect your business. Financial reports summarize the results of financial transactions affecting a business and report its current financial position. They indicate how well your business is doing. Many groups or individuals may be interested in your business’s finances. These may include:

• potential buyers

• government agencies

• banks or other financial institutions

• employees and consumers

Accounting Assumptions and the Accounting Cycle

When you’re creating the accounting books for your business, you will make two assumptions about your business. The first is that your business will operate as a separate unit or business entity. This means that the records and reports of your business will be kept completely separate from your personal finances. You never mix your business finances with your personal finances.

The second assumption is that your business makes its financial reports in specific blocks of time. A block of time covered by an accounting report is called an accounting period. The accounting period can be one month or one quarter (three months), but the most common period is one year.

During this accounting period, you record all financial transactions for your business and report the results. You’ll be responsible for many activities that maintain your accounting records in an orderly manner. The activities, or steps, that help a business keep its accounting records in an orderly manner make up the accounting cycle.

You probably have heard news items such as: “Ford sales are up 4 percent over last quarter and up 6 percent from the same quarter last year.” By using a set period of time and the accounting cycle, you can compare financial reports from one period to those from another period.

The Accounting Equation

Property is anything of value that you own or control. Both people and businesses have property. You might own a CD player, a computer, clothes, a television set, or maybe a car. For a business, property could include cash, office equipment, supplies, merchandise, or vehicles. When you own an item of property, you have a legal right or financial claim to that item. In contrast, when you have control over an item, you have the right to the use of it. A rented office is property, but a business does not have a financial claim to it. In accounting property or items of value used by your business are called assets.

Your equity in a piece of property is your share of its value, or your financial claim to the property. This also applies to business. For example, suppose that your business owns a truck valued at $16,000. You’re the owner of the business, so your equity in the truck is $16,000. If the truck is completely paid for, you’re the only one with a financial claim to the truck. An owner’s claim to the assets of a business is called owner’s equity.

However, what if you still owe $3,000 to the Stratford Savings Bank for the truck? The truck is valued at $16,000, but the creditor (the bank) has $3,000 equity, while your equity is now only $13,000. Both you and the creditor have financial claims to (equity in) the asset.

Property = Creditor’s Financial Claim + Owner’s Financial Claim

$16,000 = $3,000 + $13,000

Creditors’ claims to the assets of a business are called liabilities, or the debts of a business. The relationship between assets and the two types of equity (liabilities and owner’s equity) is shown in the accounting equation.

Property = Creditor’s Financial Claim + Owner’s Financial Claim

Assets = Liabilities + Owner’s Equity

The accounting equation (assets = liabilities + owner’s equity) is the basis for keeping all accounting records in balance. The entire system of accounting is based on this equation. As your business buys, sells, or exchanges goods and services involving many business transactions, the number may change. However, total assets will always be equal to total liabilities plus owner’s equity. As you learn more, you’ll understand why this equation is so important.

Establishing Accounts

When you set up the books of a business, you create accounts for each of the three categories in the accounting equation: assets, liabilities, and owner’s equity. An account shows the balance for a specific item, such as cash or equipment. You must look at your business and determine what accounts your business needs. Businesses create only the accounts they need for their type of business operation. The accounts used by one business may be different from the accounts used by another.

Chris Archer uses the following accounts for his business, Archer Delivery Service.

|ASSETS |LIABILITIES |OWNER’S EQUITY |

|Cash in Bank |Accounts Payable |Owner’s, capital |

|Accounts Receivable | | |

|Office Equipment | | |

|Delivery Equipment | | |

Chris has established four asset accounts. The first will show all of the cash that enters or leaves the business. It’s called Cash in Bank because all cash received by his business is deposited in a bank account, and all cash paid out is paid by check. In accounting, cash and checks are both considered cash transactions.

The second asset account is Accounts Receivable. Accounts receivable is the total amount of money owed to a business by customers. Chris completed deliveries for other companies, and they owe his business money. This account represents a future value that will eventually bring cash into the business.

When Chris buys office equipment or delivery equipment, he will use these two remaining asset accounts. If he needs other accounts in his business, he can easily create them. For example, suppose that Chris buys a computer for the business. He could include it under Office Equipment, or perhaps he might create another assets account called Computer Equipment.

The only liability account listed is Accounts Payable. Accounts payable is the amount of money owed, or payable, to the creditors of a business. The balance owed will remain in Accounts Payable until the business pays the debt.

Finally, the owner’s equity account is identified Owner’s Capital. The capital account will report the owner’s investment in the assets of the business.

T Accounts

When accountants analyze and record business transactions, they use a system called double-entry accounting. Double-entry accounting is a system of recordkeeping in which each business transaction affects at least two accounts. Remember Archer Delivery Service has six accounts that can be used.

An efficient way to understand double-entry accounting is to use T accounts. T accounts show the dollar increase or decrease in each account that is affected by a transaction.

|Account Name |

|Left Side |Right Side |

|Debit |Credit |

As you can see by this illustration, a T Account has the account name at the top and has a left side and a right side. An amount entered on the left side of a T account is called debit. An amount entered on the right side of a T account is called credit.

Debits and credits are used to record the increase or decreases in accounts affected by a business transaction. Under double-entry accounting, for each debit in one account (or accounts) there must be a credit of an equal amount in another account (or accounts).

The rules of debit and credit vary, depending on whether the account is an asset, liability or owner’s equity account. Basically, if an account is classified on the left side of the accounting equation, the account is increased on the left side (or debit side) of the T account. Similarly, if an account is classified on the right side of the accounting equation, the account is increased on the right side (or credit side) of the T account. Therefore, asset accounts increase on the debit side of the T account. Liability and owner’s equity accounts increase on the credit side of the T account.

To decrease the amount in an account, use the opposite side of the T account. For example, if asset accounts are increased on the debit side, they are decreased on the credit side. Since liability and owner’s equity accounts increase on the credit side, they are decreased on the debit side.

No matter how many accounts a business may have, all business transactions are analyzed in the same way: Every transaction will have debit and credit entries, and they will always be equal in amount.

All Things Being Equal Name:____________________________________

In this chapter you are learning about the all important accounting equation. If it’s in balance, then you know you accounting procedures are OK. If the equation gets out of balance, then you’ve got some work to do. In this activity, you’ll analyze some business accounts and determine where in the accounting equation they belong.

First fill in the three parts of the accounting equation for Hector and Dory’s catering business. Then read the ten items in the box. Decide where in the equation the item belongs and write it in the proper place.

Loan from to Dory’s mother

Cash in Bank

Computer Equipment

Loan for delivery van

Office Equipment

Delivery Van

Accounts Payable

Accounts Receivable

Owner’s capital

| |= | |+ | |

| | | | | |

| | | | | |

| | | | | |

| | | | | |

| | | | | |

| | | | | |

Accounts Payable:

Accounts Receivable:

Owner’s Capital:

Working With the Accounting Equation Name:____________________________________

Problem 1

You bought a coat for $60 cash. In equation form, what is the relationship between the asset and your financial claims?

| |= | |

| |= | |

Problem 2

You want to buy a bicycle that costs $200, but you have only $45. E and T Sports Store agrees to sell you the bicycle on credit. You pay $45 down and sign an agreement to pay the remaining $155 in installment payments. How can you show this purchase using the accounting equation?

| |= | |

| |= | |+ | |

Problem 3

Same Day Cleanser just bought a new cash register for $2,400. The business made a down payment of $400 and borrowed the remaining $2,000 from a local bank. How does the accounting equation apply in this example?

| |= | |

| |= | |+ | |

Problem 4

The account names used by Alexander Company are listed below. Indicate which accounts are assets, liabilities, and owner’s equity.

Accounts Payable

Accounts Receivable

Cash in Bank

Computer Equipment

Store Equipment

Owner’s Capital

|Assets: | |

|Liabilities: | |

|Owner’s Equity: | |

Analyzing Transactions Name:____________________________________

Marion Butler is the owner of Butler Florists which opened its doors for business just yesterday. Butler Florists uses the following accounts:

Cash in Bank

Accounts Receivable

Office Equipment

Delivery Equipment

Accounts Payable

Owner Capital

Read each transaction and:

1. Identify the accounts affected

2. Classify the accounts affected

3. Determine the amount of increase or decrease for each account

4. Show the new account balances in the accounting equation

| |ASSETS |= |LIAB. |+ |OWNER EQ. |

| |Cash in Bank |

| | |

| | |

| | |

| | |

| | |

| | |

| | |

| | |

| | | | | | | | | | | | | | | | | | | | |= | |+ | | |

Check Your Understanding

1. Define these terms:

a. financial reports:

b. GAAP:

c. business entity:

d. transaction:

e. accounting period:

f. accounting cycle:

g. asset:

h. creditor:

i. liability:

j. owner’s equity:

k. accounting equation:

l. account:

m. double-entry accounting:

n. debit:

o. credit:

2. Name at least four individuals or groups who might be interested in the financial reports of a business.

3. What rules tell business owners how to keep their financial records?

4. Bruno owns a small printing business. He uses the same checkbook to write personal and business checks. He also keeps receipts for purchases of everything, from groceries to reams of paper, in the same file. What basic assumption of accounting is Bruno ignoring?

5. Spell out the accounting equation and explain how it is related to setting up the books of a business.

6. Otto owns a bicycle shop and deposits all incoming cash and checks in a bank account. He also pays all expenses by check. Otto has set up four accounts in the asset category: Cash in Bank, Accounts Receivable, Bicycle Repair Equipment, and Bicycle Inventory. Describe what each account should show.

a. Cash in Bank

b. Accounts Receivable

c. Bicycle Repair Equipment

d. Bicycle Inventory

7. What system of recordkeeping is used when each business transaction affects at least two accounts?

8. What tool is used to analyze business transactions in double-entry accounting?

9. Why do asset accounts increase on the debit side?

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financial reports

GAAP

business entity

accounting period

accounting cycle

creditor

asset

liability

owner’s equity

accounting equation

account

accounts receivable

accounts payable

capital

double-entry accounting

T accounts

debit

credit

1. Prepare Source Documents

4. Prepare a Trial Balance and Worksheet

5. Prepare Financial Statements

2. Record Transactions in a Journal

3. Record information for individual accounts

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