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Analyzing Business Chapter 2

Transactions

www.southwest.com
Rollin King and Herb Kelleher had a
simple notion when they got into the
airline business: “If you get your pas-
sengers to their destinations when they
want to get there, on time, at the low-
est possible fares, and make darn sure
they have a good time doing it, peo-
ple will fly your airline.”
Today, Southwest has become one
of the most profitable airlines—posting
a profit for the 40th consecutive year in
a row! However, running an airline is
no easy task. Think of all of the finan-
cial transactions that take place on a
daily basis. The airline has to buy planes, equipment, and supplies—like those peanuts we are so fond of. It also has to pay employees,
pay for repairs on their equipment, and buy insurance, just to name a few expenses. Then, it has to sell enough tickets in order to be able
to generate money to pay for all of these things. Yikes. That is a lot of cash coming in and going out. With an emphasis on customer serv-
ice, Southwest has a reputation of being fun, quirky, and having a sense of humor. You never know what might happen when you board
a Southwest flight but you know you’ll have a good time.

thinking critically
How does Southwest keep track of all of these transactions so that it can continue to run its airlines profitably?

LEARNING OBJECTIVES NEW TERMS

2-1. Record in equation form the financial effects of a business accounts payable equation
transaction. accounts receivable income statement
2-2. Define, identify, and understand the relationship between assets liabilities
asset, liability, and owner’s equity accounts. balance sheet net income
2-3. Analyze the effects of business transactions on a firm’s assets, break even net loss
liabilities, and owner’s equity and record these effects in business transaction on account
accounting equation form. capital owner’s equity
2-4. Prepare an income statement. equity revenue
2-5. Prepare a statement of owner’s equity and a balance sheet. expense statement of owner’s
fair market value equity
2-6. Define the accounting terms new to this chapter.
fundamental accounting withdrawals
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Section 1
SECTION OBJECTIVES TERMS TO LEARN
>> 2-1. Record in equation form the financial effects of a business transaction. accounts payable
WHY IT’S IMPORTANT assets
Learning the fundamental accounting equation is a basis for understanding business balance sheet
transactions. business transaction
capital
>> 2-2. Define, identify, and understand the relationship between asset, equity
liability, and owner’s equity accounts. liabilities
WHY IT’S IMPORTANT on account
The relationship between assets, liabilities, and owner’s equity is the basis for the entire owner’s equity
accounting system.

Property and
Financial Interest
The accounting process starts with the analysis of business transactions. A business transaction
is any financial event that changes the resources of a firm. For example, purchases, sales, pay-
ments, and receipts of cash are all business transactions. The accountant analyzes each business
transaction to decide what information to record and where to record it.

>>2-1. OBJECTIVE Beginning with Analysis

Record in equation form the financial Let’s analyze the transactions of Wells’ Consulting Services, a firm that provides a wide range
effects of a business transaction. of accounting and consulting services. Carolyn Wells, CPA, has a master’s degree in account-
ing. She is the sole proprietor of Wells’ Consulting Services. Carlos Valdez, the office manager,
has an associate’s degree in business and has taken 12 semester hours of accounting. The firm
is located in a large office complex.
Every month, Wells’ Consulting Services bills clients for the accounting and consulting
services provided that month. Customers can also pay in cash when the services are rendered.

STARTING A BUSINESS
Let’s start from the beginning. Carolyn Wells obtained the funds to start the business by with-
drawing $100,000 from her personal savings account. The first transaction of the new business
was opening a checking account in the name of Wells’ Consulting Services. The separate bank
account helps Wells keep her financial interest in the business separate from her personal funds.
When a business transaction occurs, it is analyzed to identify how it affects the equation
property equals financial interest. This equation reflects the fact that in a free enterprise sys-
tem, all property is owned by someone. In this case, Wells owns the business because she sup-
plied the property (cash).
Use these steps to analyze the effect of a business transaction:
1. Describe the financial event.
• Identify the property.
• Identify who owns the property.
22 • Determine the amount of increase or decrease.
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Analyzing Business Transactions CHAPTER 2 23

2. Make sure the equation is in balance.

Property 5 Financial Interest

BUSINESS TRANSACTION

Carolyn Wells withdrew $100,000 from personal savings and deposited it in a new checking
account in the name of Wells’ Consulting Services.

>>
ANALYSIS
a. The business received $100,000 of property in the form of cash.
a. Wells had a $100,000 financial interest in the business.
Note that the equation property equals financial interest remains in balance. The total of one
side of the equation must always equal the total of the other side.

Property 5 Financial Interest

Cash 5 Carolyn Wells, Capital

(a) Invested cash 1$100,000

(a) Increased equity 1$100,000
New balances $100,000 5 $100,000

An owner’s financial interest in the business is called equity, or capital. Carolyn Wells
has $100,000 equity in Wells’ Consulting Services.

PURCHASING EQUIPMENT FOR CASH

The first priority for office manager Carlos Valdez was to get the business ready for opening
day on December 1.

BUSINESS TRANSACTION

Wells’ Consulting Services issued a $5,000 check to purchase a computer and other equipment.
>>

ANALYSIS
b. The firm purchased new property (equipment) for $5,000.
b. The firm paid out $5,000 in cash.
The equation remains in balance.
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24 CHAPTER 2 Analyzing Business Transactions

Property 5 Financial Interest

Cash 1 Equipment 5 Carolyn Wells, Capital

Previous balances $100,000 5 $100,000

(b) Purchased equipment 1 $5,000
(b) Paid cash 25,000

New balances $95,000 1 $5,000 5 $100,000

Notice that there is a change in the composition of the firm’s property. Now the firm has
cash and equipment. The equation shows that the total value of the property remains the same,
$100,000. Carolyn Wells’ financial interest, or equity, is also unchanged. Note that property
(Cash and Equipment) is equal to financial interest (Carolyn Wells, Capital).
These activities are recorded for the business entity Wells’ Consulting Services. Carolyn
Wells’ personal assets, such as her personal bank account, house, furniture, and automobile, are
kept separate from the property of the firm. Nonbusiness property is not included in the
accounting records of the business entity.

PURCHASING EQUIPMENT ON CREDIT

Valdez purchased additional office equipment. Office Plus, the store selling the equipment,
allows Wells’ Consulting Services 60 days to pay the bill. This arrangement is called buying
on account. The business has a charge account, or open-account credit, with its suppliers.
Amounts that a business must pay in the future are known as accounts payable. The com-
panies or individuals to whom the amounts are owed are called creditors.

BUSINESS TRANSACTION

Wells’ Consulting Services purchased office equipment on account from Office Plus for
$6,000.
>>

ANALYSIS
c. The firm purchased new property (equipment) that cost $6,000.
c. The firm owes $6,000 to Office Plus.
The equation remains in balance.

Property 5 Financial Interest

ABOUT
Accounts Carolyn Wells,
ACCOUNTING Cash 1 Equipment 5 Payable 1 Capital
History
For as long as people have been Previous balances $95,000 1 $ 5,000 5 $100,000
involved in business, there has been a (c) Purchased equip. 1 6,000 5
need for accounting. The system of (c) Incurred debt 1$6,000
accounting we use is based upon the New balances $95,000 1 $11,000 5 $6,000 1 $100,000
works of Luca Pacioli, a Franciscan
monk in Italy. In 1494, Pacioli wrote
about the bookkeeping techniques in
Office Plus is willing to accept a claim against Wells’ Consulting Services until the bill is
practice during his time. paid. Now there are two different financial interests or claims against the firm’s property—the
creditor’s claim (Accounts Payable) and the owner’s claim (Carolyn Wells, Capital). Notice
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Analyzing Business Transactions CHAPTER 2 25

that the total property increases to $106,000. Cash is $95,000 and equipment is $11,000.
Carolyn Wells, Capital stays the same; but the creditor’s claim increases to $6,000. After this
transaction is recorded, the left side of the equation still equals the right side.

When Ben Cohen and Jerry Greenfield founded Ben & Jerry’s Homemade Ice Cream, Inc., in 1978,
they invested $8,000 of their own funds and borrowed funds of $4,000. The equation property equals
financial interest is expressed as
Property 5 Financial Interest
cash 5 creditors’ claims
1 owners’ claims
$12,000 5 $ 4,000
18,000
$12,000

PURCHASING SUPPLIES
Valdez purchased supplies so that Wells’ Consulting Services could start operations. The com-
pany that sold the items requires cash payments from companies that have been in business less
than six months.

BUSINESS TRANSACTION

Wells’ Consulting Services issued a check for $1,500 to Office Delux, Inc., to purchase office
supplies.
>>

ANALYSIS
d. The firm purchased office supplies that cost $1,500.
d. The firm paid $1,500 in cash.
The equation remains in balance.

Property 5 Financial Interest

Accounts Carolyn Wells,
Cash 1 Supplies 1 Equipment 5 Payable 1 Capital

Previous balances $95,000 1 $11,000 5 $6,000 1 $100,000

(d) Purchased supplies 1 $ 1,500
(d) Paid cash 2$1,500

New balances $93,500 1 $1,500 1 $11,000 5 $6,000 1 $100,000

Notice that total property remains the same, even though the form of the property has changed.
Also note that all of the property (left side) equals all of the financial interests (right side).

PAYING A CREDITOR
Valdez decided to reduce the firm’s debt to Office Plus by $2,500.
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26 CHAPTER 2 Analyzing Business Transactions

BUSINESS TRANSACTION

Wells’ Consulting Services issued a check for $2,500 to Office Plus.

>>
ANALYSIS
e. The firm paid $2,500 in cash.
e. The claim of Office Plus against the firm decreased by $2,500.
The equation remains in balance.

Property 5 Financial Interest

Accounts Carolyn Wells,
Cash 1 Supplies 1 Equipment 5 Payable 1 Capital

Previous balances $93,500 1 $1,500 1 $11,000 5 $6,000 1 $100,000

(e) Paid cash 2$2,500
(e) Decreased debt 2$2,500
New balances $91,000 1 $1,500 1 $11,000 5 $3,500 1 $100,000

RENTING FACILITIES
In November, Valdez arranged to rent facilities for $4,000 per month, beginning in December.
The landlord required that rent for the first two months—December and January—be paid in
advance. The firm prepaid (paid in advance) the rent for two months. As a result, the firm
obtained the right to occupy facilities for a two-month period. In accounting, this right is con-
sidered a form of property.

BUSINESS TRANSACTION

Wells’ Consulting Services issued a check for $8,000 to pay for rent for the months of December
and January.
>>

ANALYSIS
f. The firm prepaid the rent for the next two months in the amount of $8,000.
f. The firm decreased its cash balance by $8,000.
The equation remains in balance.

Property 5 Financial Interest

Prepaid Accounts Carolyn Wells,
Cash 1 Supplies 1 Rent 1 Equipment 5 Payable 1 Capital

Previous balances $91,000 1 $1,500 1 $11,000 5 $3,500 1 $100,000

(f) Paid cash 2$8,000
(f) Prepaid rent 1$8,000
New balances $83,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000
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Analyzing Business Transactions CHAPTER 2 27

Notice that when property values and financial interests increase or decrease, the total of the
items on one side of the equation still equals the total on the other side.
Property 5 Financial Interest
Cash $ 83,000 Accounts Payable $ 3,500
Supplies 1,500 Carolyn Wells, Capital 100,000
Prepaid Rent 8,000
Equipment 11,000
Total $103,500 Total $103,500

The balance sheet is also called the statement of financial position. Caterpillar Inc. reported assets of $89.4
billion, liabilities of $71.8 billion, and owners’ equity of $17.6 billion on its statement of financial position
at December 31, 2012.

Assets, Liabilities, and Owner’s Equity >>2-2. OBJECTIVE

Accountants use special accounting terms when they refer to property and financial interests. Define, identify, and understand the
For example, they refer to the property that a business owns as assets and to the debts or obli- relationship between asset, liability,
gations of the business as liabilities. The owner’s financial interest is called owner’s equity. and owner’s equity accounts.
(Sometimes owner’s equity is called proprietorship or net worth. Owner’s equity is the pre-
ferred term and is used throughout this book.) At regular intervals, Wells reviews the status of
the firm’s assets, liabilities, and owner’s equity in a financial statement called a balance sheet.
The balance sheet shows the firm’s financial position on a given date. Figure 2.1 shows the
firm’s balance sheet on November 30, the day before the company opened for business.
The assets are listed on the left side of the balance sheet and the liabilities and owner’s
equity are on the right side. This arrangement is similar to the equation property equals finan-
cial interest. Property is shown on the left side of the equation, and financial interest appears on
the right side.
The balance sheet in Figure 2.1 shows:
■ the amount and types of property the business owns,
■ the amount owed to creditors,
■ the owner’s interest.
This statement gives Carolyn Wells a complete picture of the financial position of her busi-
ness on November 30.

FIGURE 2.1 Balance Sheet for Wells’ Consulting Services

Wells’ Consulting Services

Balance Sheet
November 30, 2016

Assets Liabilities
Cash 83 0 0 0 00 Accounts Payable 3 5 0 0 00
Supplies 1 5 0 0 00
Prepaid Rent 8 0 0 0 00 Owner’s Equity
Equipment 11 0 0 0 00 Carolyn Wells, Capital 100 0 0 0 00
Total Assets 103 5 0 0 00 Total Liabilities and Owner’s Equity 103 5 0 0 00
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28 CHAPTER 2 Analyzing Business Transactions

Section 1 Self Review

QUESTIONS c. $126,000 A N A LY S I S
1. Describe a transaction that increases an asset and d. $150,000 6. China Import Co. has no liabilities. The asset and
the owner’s equity. 5. Teresa Wells purchased a computer for $2,950 on owner’s equity balances are as follows. What is
2. What does the term “accounts payable” mean? account for her business. What is the effect of this the balance of “Supplies”?
3. What is a business transaction? transaction? Cash $ 50,000
a. Equipment increase of $2,950 and accounts Office Equipment $ 30,000
EXERCISES
payable increase of $2,950. Supplies ????
4. John Ellis began a new business by depositing
b. Equipment decrease of $2,950 and accounts John Wong, Capital $100,000
$150,000 in the business bank account. He wrote
payable increase of $2,950.
two checks from the business account: $24,000
for office furniture and $8,000 for office supplies. c. Equipment increase of $2,950 and cash
increase of $2,950. (Answers to Section 1 Self Review are on
What is his financial interest in the company? page 50.)
a. $122,000 d. Cash decrease of $2,950 and owner’s equity
increase of $2,950.
b. $118,000
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Section 2
SECTION OBJECTIVES TERMS TO LEARN
>> 2-3. Analyze the effects of business transactions on a firm’s assets, liabili- accounts receivable
ties, and owner’s equity and record these effects in accounting equa- break even
tion form. expense
WHY IT’S IMPORTANT fair market value
Property will always equal financial interest. fundamental accounting
equation
>> 2-4. Prepare an income statement. income statement
WHY IT’S IMPORTANT net income
The income statement shows the results of operations. net loss
revenue
>> 2-5. Prepare a statement of owner’s equity and a balance sheet.
statement of owner’s equity
WHY IT’S IMPORTANT
withdrawals
These financial statements show the financial condition of a business.

The Accounting Equation

and Financial Statements
The word balance in the title “balance sheet” has a special meaning. It emphasizes that the total
on the left side of the report must equal, or balance, the total on the right side.

The Fundamental Accounting Equation

In accounting terms, the firm’s assets must equal the total of its liabilities and owner’s equity. >>2-3. OBJECTIVE
This equality can be expressed in equation form, as illustrated here. The amounts are for Wells’ Analyze the effects of business
Consulting Services on November 30. transactions on a firm’s assets,
liabilities, and owner’s equity and
Assets 5 Liabilities 1 Owner’s Equity
record these effects in accounting
$103,500 5 $3,500 1 $100,000 equation form.
The relationship between assets and liabilities plus owner’s equity is called the fundamental
accounting equation. The entire accounting process of analyzing, recording, and reporting
business transactions is based on the fundamental accounting equation.
If any two parts of the equation are known, the third part can be determined. For example,
consider the basic accounting equation for Wells’ Consulting Services on November 30, with
some information missing.
Assets 5 Liabilities 1 Owner’s Equity
1. ? 5 $3,500 1 $100,000
2. $103,500 5 ? 1 $100,000
3. $103,000 5 $3,500 1 ?

In the first case, we can solve for assets by adding liabilities to owner’s equity ($3,500 1
$100,000) to determine that assets are $103,500. In the second case, we can solve for liabilities important!
by subtracting owner’s equity from assets ($103,500 2 $100,000) to determine that liabilities
are $3,500. In the third case, we can solve for owner’s equity by subtracting liabilities from Revenues increase owner’s equity.
assets ($103,500 2 $3,500) to determine that owner’s equity is $100,000. Expenses decrease owner’s equity.
29
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30 CHAPTER 2 Analyzing Business Transactions

EARNING REVENUE AND INCURRING EXPENSES

Wells’ Consulting Services opened for business on December 1. Some of the other businesses
in the office complex became the firm’s first clients. Wells also used her contacts in the com-
munity to identify other clients. Providing services to clients started a stream of revenue for the
business. Revenue, or income, is the inflow of money or other assets that results from the
sales of goods or services or from the use of money or property. A sale on account does not
increase money, but it does create a claim to money. When a sale occurs, the revenue increases
assets and also increases owner’s equity.
An expense, on the other hand, involves the outflow of money, the use of other assets, or
the incurring of a liability. Expenses include the costs of any materials, labor, supplies, and
services used to produce revenue. Expenses cause a decrease in owner’s equity.
A firm’s accounting records show increases and decreases in assets, liabilities, and owner’s
equity as well as details of all transactions involving revenue and expenses. Let’s use the fun-
damental accounting equation to show how revenue and expenses affect the business.

SELLING SERVICES FOR CASH

During the month of December, Wells’ Consulting Services earned a total of $36,000
in revenue from clients who paid cash for accounting and bookkeeping services. This
involved several transactions throughout the month. The total effect of these transactions is
analyzed below.

>>
ANALYSIS
g. The firm received $36,000 in cash for services provided to clients.
g. Revenues increased by $36,000, which results in a $36,000 increase in owner’s equity.
The fundamental accounting equation remains in balance.

Assets 5 Liabilities 1 Owner’s Equity

Prepaid Accounts Carolyn Wells,
Cash 1 Supplies 1 Rent 1 Equipment 5 Payable 1 Capital 1 Revenue

Previous balances $ 83,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000

(g) Received cash 1$36,000
(g) Increased
owner’s equity
by earning revenue 1 $36,000
New balances $119,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $ 36,000
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$139,500 $139,500

Notice that revenue amounts are recorded in a separate column under owner’s equity. Keep-
ing revenue separate from the owner’s equity will help the firm compute total revenue more
easily when the financial statements are prepared.

SELLING SERVICES ON CREDIT

Wells’ Consulting Services has some charge account clients. These clients are allowed 30 days
to pay. Amounts owed by these clients are known as accounts receivable. This is a new form
of asset for the firm—claims for future collection from customers. During December, Wells’
Consulting Services earned $11,000 of revenue from charge account clients. The effect of these
transactions is analyzed as follows:
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Analyzing Business Transactions CHAPTER 2 31

>>
ANALYSIS
h. The firm acquired a new asset, accounts receivable, of $11,000.
h. Revenues increased by $11,000, which results in an $11,000 increase in owner’s equity.
The fundamental accounting equation remains in balance.

Assets 5 Liab. 1 Owner’s Equity

Accts. Prepaid Accts. Carolyn Wells,
Cash 1 Rec. 1 Supp. 1 Rent 1 Equip. 5 Pay. 1 Capital 1 Rev.

Previous balances $119,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $36,000

(h) Received new
asset—accts. rec. 1$11,000
(h) Increased
owner’s equity by
earning revenue 1 $11,000
New balances $119,000 1 $11,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $47,000

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$150,500 $150,500

COLLECTING RECEIVABLES
During December, Wells’ Consulting Services received $6,000 on account from clients who
owed money for services previously billed. The effect of these transactions is analyzed below.
>>

ANALYSIS
i. The firm received $6,000 in cash.
i. Accounts receivable decreased by $6,000.
The fundamental accounting equation remains in balance.

Assets 5 Liab. 1 Owner’s Equity

Accts. Prepaid Accts. Carolyn Wells,
Cash 1 Rec. 1 Supp. 1 Rent 1 Equip. 5 Pay. 1 Capital 1 Rev.

Previous balances $119,000 1 $11,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $47,000
(i) Received cash 1$6,000
(i) Decreased
accounts receivable 2$6,000

New balances $125,000 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $47,000
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$150,500 $150,500

In this type of transaction, one asset is changed for another asset (accounts receivable for
cash). Notice that revenue is not increased when cash is collected from charge account clients.
The revenue was recorded when the sale on account took place (see entry (h)). Notice that the
fundamental accounting equation, assets equal liabilities plus owner’s equity, stays in balance
regardless of the changes arising from individual transactions.
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32 CHAPTER 2 Analyzing Business Transactions

PAYING EMPLOYEES’ SALARIES

So far Wells has done very well. Her equity has increased by the revenues earned. However,
running a business costs money, and these expenses reduce owner’s equity.
During the first month of operations, Wells’ Consulting Services hired an accounting clerk.
The salaries for the new accounting clerk and the office manager are considered an expense to
the firm.

BUSINESS TRANSACTION

In December, Wells’ Consulting Services paid $8,000 in salaries for the accounting clerk and
Carlos Valdez.

>>
ANALYSIS
j. The firm decreased its cash balance by $8,000.
j. The firm paid salaries expense in the amount of $8,000, which decreased owner’s equity.
The fundamental accounting equation remains in balance.

Assets 5 Liab. 1 Owner’s Equity

Accts Prepaid Accts. Carolyn Wells,
Cash 1 Rec. 1 Supp. 1 Rent 1 Equip. 5 Pay. 1 Capital 1 Rev. 2 Exp.

Previous balances $125,000 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $47,000
(j) Paid cash 2$8,000
(j) Decreased
owner’s equity
by incurring
salaries exp. 1 $8,000
New balances $117,000 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $47,000 2 $8,000
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$142,500 $142,500

Notice that expenses are recorded in a separate column under owner’s equity. The separate
record of expenses is kept for the same reason that the separate record of revenue is kept—to
analyze operations for the period.

PAYING UTILITIES EXPENSE

At the end of December, the firm received a $650 utilities bill.

BUSINESS TRANSACTION

Wells’ Consulting Services issued a check for $650 to pay the utilities bill.
>>

ANALYSIS
k. The firm decreased its cash balance by $650.
k. The firm paid utilities expense of $650, which decreased owner’s equity.
The fundamental accounting equation remains in balance.
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Assets 5 Liab. 1 Owner’s Equity

Accts. Prepaid Accts. C. Wells,
Cash 1 Rec. 1 Supp. 1 Rent 1 Equip. 5 Pay. 1 Capital 1 Rev. 2 Exp.

Previous balances $117,000 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $47,000 2 $8,000
(k) Paid cash 2$650
(k) Decreased
owner’s equity by
utilities exp. 1 $650
New balances $116,350 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $47,000 2 $8,650
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$141,850 $141,850

EFFECT OF OWNER’S WITHDRAWALS

On December 30, Wells withdrew $5,000 in cash for personal expenses. Withdrawals are
funds taken from the business by the owner for personal use. Withdrawals are not a business
expense but a decrease in the owner’s equity.

BUSINESS TRANSACTION

Carolyn Wells wrote a check to withdraw $5,000 cash for personal use.
>>

ANALYSIS
l. The firm decreased its cash balance by $5,000.
l. Owner’s equity decreased by $5,000.
The fundamental accounting equation remains in balance.

Assets 5 Liab. 1 Owner’s Equity

Accts. Prepaid Accts. Carolyn Wells,
Cash 1 Rec. 1 Supp. 1 Rent 1 Equip. 5 Pay. 1 Capital 1 Rev. 2 Exp.

Previous balances $116,350 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $100,000 1 $47,000 2 $8,650
(l) Withdrew cash 2$5,000
(l) Decreased
owner’s equity 2 $ 5,000
New balances $111,350 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $95,000 1 $47,000 2 $8,650
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$136,850 $136,850

SUMMARY OF TRANSACTIONS
Figure 2.2 on page 34 summarizes the transactions of Wells’ Consulting Services through
December 31. Notice that after each transaction, the fundamental accounting equation is in bal-
ance. Test your understanding by describing the nature of each transaction. Then check your
results by referring to the discussion of each transaction.
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34 CHAPTER 2 Analyzing Business Transactions

FIGURE 2.2 Transactions of Wells’ Consulting Services Through December 31, 2016

Assets 5 Liab. 1 Owner’s Equity

Accts. Prepaid Accts. C. Wells,
Cash 1 Rec. 1 Supp. 1 Rent 1 Equip. 5 Pay. 1 Capital 1 Rev. 2 Exp.

(a) 1$100,000
________ 1 $100,000
______
Balances 100,000 5 100,000
(b) 25,000
________ 1 $5,000
_____
Balances 95,000 1 5,000 5 100,000
(c) ________ 1 6,000
_____ 1 $6,000
_____ ______
Balances 95,000 1 11,000 5 6,000 1 100,000
(d) 21,500
________ $1,500
1 _____ _____ _____ ______
Balances 93,500 1 1,500 1 11,000 5 6,000 1 100,000
(e) 22,500
________ _____ _____ 2 2,500
_____ ______
Balances 91,000 1 1,500 1 11,000 5 3,500 1 100,000
(f) 28,000
________ _____ 1 $8,000
_____ _____ _____ ______
Balances 83,000 1 1,500 1 8,000 1 11,000 5 3,500 1 100,000
(g) 136,000
________ _____ _____ _____ _____ ______ 1 $36,000
_____
Balances 119,000 1 1,500 1 8,000 1 11,000 5 3,500 1 100,000 1 36,000
(h) ________ 1 $11,000
_____ _____ _____ _____ _____ ______ 1 11,000
_____
Balances 119,000 1 11,000 1 1,500 1 8,000 1 11,000 5 3,500 1 100,000 1 47,000
(i) ________ 2
16,000 6,000
_____ _____ _____ _____ _____ ______ _____
Balances 125,000 1 5,000 1 1,500 1 8,000 1 11,000 5 3,500 1 100,000 1 47,000
(j) 28,000
________ _____ _____ _____ _____ _____ ______ $8,000
_____ 1 _____
Balances 117,000 1 5,000 1 1,500 1 8,000 1 11,000 5 3,500 1 100,000 1 47,000 2 8,000
(k) 2650
________ _____ _____ _____ _____ _____ ______ _____ 1 650
_____
Balances 116,350 1 5,000 1 1,500 1 8,000 1 11,000 5 3,500 1 100,000 1 47,000 2 8,650
(l) 25,000
________ _____ _____ _____ _____ _____ 2 5,000
______ _____ _____
Balances $111,350 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $95,000 1 $47,000 2 $8,650
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$136,850 $136,850

The Income Statement

To be meaningful to owners, managers, and other interested parties, financial statements should pro-
vide information about revenue and expenses, assets and claims on the assets, and owner’s equity.
The income statement shows the results of business operations for a specific period of
>>2-4. OBJECTIVE time such as a month, a quarter, or a year. The income statement shows the revenue earned and
Prepare an income statement. the expenses of doing business. (The income statement is sometimes called a profit and loss
statement or a statement of income and expenses. The most common term, income statement, is
used throughout this text.) Figure 2.3 shows the income statement for Wells’ Consulting Ser-
r reeccaal ll l vices for its first month of operation.
The income statement shows the difference between revenue from services provided or goods
Financial Statements sold and the amount spent to operate the business. Net income results when revenue is greater
Financial statements are reports that than the expenses for the period. When expenses are greater than revenue, the result is a net loss.
summarize a firm’s financial affairs. In the rare case when revenue and expenses are equal, the firm is said to break even. The
income statement in Figure 2.3 shows a net income; revenue is greater than expenses.
The three-line heading of the income statement shows who, what, and when.
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Analyzing Business Transactions CHAPTER 2 35

Wells’ Consulting Services

FIGURE 2.3
Income Statement Income Statement for Wells’
Month Ended December 31, 2016 Consulting Services
Revenue
Fees Income 4 7 0 0 0 00
Expenses
Salaries Expense 8 0 0 0 00
Utilities Expense 6 5 0 00
Total Expenses 8 6 5 0 00
Net Income 3 8 3 5 0 00

■ Who—the business name appears on the first line.

■ What—the report title appears on the second line.
■ When—the period covered appears on the third line.
The third line of the income statement heading in Figure 2.3 indicates that the report covers
operations for the “Month Ended December 31, 2016.” Review how other time periods are
reported on the third line of the income statement heading.

Period Covered Third Line of Heading

Jan., Feb., Mar. Three-Month Period Ended March 31, 2016

Jan. to Dec. Year Ended December 31, 2016
July 1 to June 30 Fiscal Year Ended June 30, 2016

Note the use of single and double rules in amount columns. A single line is used to show that
the amounts above it are being added or subtracted. Double lines are used under the final
amount in a column or section of a report to show that the amount is complete. Nothing is
added to or subtracted from an amount with a double line.

Some companies refer to the income statement as the statement of operations. American Eagle Outfitters,
Inc., reported $3.16 billion in sales on consolidated statements of operations for the fiscal year ended
January 2012.

The income statement for Wells’ Consulting Services does not have dollar signs because it
was prepared on accounting paper with ruled columns. However, dollar signs are used on
income statements that are prepared on plain paper, that is, not on a ruled form.

The Statement of Owner’s Equity

and the Balance Sheet >>2-5. OBJECTIVE
The statement of owner’s equity reports the changes that occurred in the owner’s financial Prepare a statement of owner’s equity
interest during the reporting period. This statement is prepared before the balance sheet so that and a balance sheet.
the amount of the ending capital balance is available for presentation on the balance sheet.
Figure 2.4 on page 36 shows the statement of owner’s equity for Wells’ Consulting Services.
Note that the statement of owner’s equity has a three-line heading: who, what, and when.
■ The first line of the statement of owner’s equity is the capital balance at the beginning of
the period.
■ Net income is an increase to owner’s equity; net loss is a decrease to owner’s equity.
■ Withdrawals by the owner are a decrease to owner’s equity.
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36 CHAPTER 2 Analyzing Business Transactions

FIGURE 2.4 Wells’ Consulting Services

Statement of Owner’s Equity for Statement of Owner’s Equity
Wells’ Consulting Services Month Ended December 31, 2016

Carolyn Wells, Capital, December 1, 2016 1 0 0 0 0 0 00

Net Income for December 3 8 3 5 0 00
Less Withdrawals for December 5 0 0 0 00
Increase in Capital 3 3 3 5 0 00
Carolyn Wells, Capital, December 31, 2016 1 3 3 3 5 0 00

■ Additional investments by the owners are an increase to owner’s equity.

■ The total of changes in equity is reported on the line “Increase in Capital” (or “Decrease
in Capital”).
■ The last line of the statement of owner’s equity is the capital balance at the end of the period.
If Carolyn Wells had made any additional investments during December, this would appear
as a separate line on Figure 2.4. Additional investments can be cash or other assets such as
equipment. If an investment is made in a form other than cash, the investment is recorded at its
fair market value. Fair market value is the current worth of an asset or the price the asset
would bring if sold on the open market.
The ending balances in the asset and liability accounts are used to prepare the balance sheet.

Assets 5 Liab. 1 Owner’s Equity

Accts. Prepaid Accts. C. Wells,
Cash 1 Rec. 1 Supp. 1 Rent 1 Equip. 5 Pay. 1 Capital 1 Rev. 2 Exp.

New balances $111,350 1 $5,000 1 $1,500 1 $8,000 1 $11,000 5 $3,500 1 $95,000 1 $47,000 2 $8,650
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$136,850 $136,850

important! The ending capital balance from the statement of owner’s equity is also used to prepare the
balance sheet. Figure 2.5 shows the balance sheet for Wells’ Consulting Services on Decem-
Financial Statements ber 31, 2016.
The balance sheet is a snapshot of the The balance sheet shows:
firm’s financial position on a specific ■ Assets—the types and amounts of property that the business owns,
date. The income statement, like a ■ Liabilities—the amounts owed to creditors,
movie or video, shows the results of ■ Owner’s Equity—the owner’s equity on the reporting date.
business operations over a period of In preparing a balance sheet, remember the following:
time. ■ The three-line heading gives the firm’s name (who), the title of the report (what), and the
date of the report (when).
■ Balance sheets prepared using the account form (as in Figure 2.5) show total assets on the
same horizontal line as the total liabilities and owner’s equity.
■ Dollar signs are omitted when financial statements are prepared on paper with ruled
columns. Statements that are prepared on plain paper, not ruled forms, show dollar signs
with the first amount in each column and with each total.
■ A single line shows that the amounts above it are being added or subtracted. Double lines
indicate that the amount is the final amount in a column or section of a report.
Figure 2.6 shows the connections among the financial statements. Financial statements are
prepared in a specific order:
■ income statement
■ statement of owner’s equity
■ balance sheet
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Analyzing Business Transactions CHAPTER 2 37

FIGURE 2.5 Balance Sheet for Wells’ Consulting Services

Wells’ Consulting Services

Balance Sheet
December 31, 2016

Assets Liabilities
Cash 111 3 5 0 00 Accounts Payable 3 5 0 0 00
Accounts Receivable 5 0 0 0 00
Supplies 1 5 0 0 00
Prepaid Rent 8 0 0 0 00 Owner’s Equity
Equipment 11 0 0 0 00 Carolyn Wells, Capital 1 3 3 3 5 0 00
Total Assets 136 8 5 0 00 Total Liabilities and Owner’s Equity 1 3 6 8 5 0 00

Step 1: Prepare the Income Statement FIGURE 2.6

Process for Preparing Financial
Wells’ Consulting Services
Statements
Income Statement
Month Ended December 31, 2016

Revenue
Fees Income 4 7 0 0 0 00
Expenses
Salaries Expense 8 0 0 0 00
Utilities Expense 6 5 0 00 Net income (or loss)
Total Expenses 8 6 5 0 00 is transferred to the
Net Income 3 8 3 5 0 00 statement of
owner’s equity.
Step 2: Prepare the Statement of Owner’s Equity

Wells’ Consulting Services

Statement of Owner’s Equity
Month Ended December 31, 2016

Carolyn Wells, Capital, December 1, 2016 1 0 0 0 0 0 00

Net Income for December 3 8 3 5 0 00
Less Withdrawals for December 5 0 0 0 00
The ending capital
Increase in Capital 3 3 3 5 0 00
balance is
Carolyn Wells, Capital, December 31, 2016 1 3 3 3 5 0 00
transferred to the
balance sheet.

Step 3: Prepare the Balance Sheet

Wells’ Consulting Services

Balance Sheet
December 31, 2016

Assets Liabilities
Cash 111 3 5 0 00 Accounts Payable 3 5 0 0 00
Accounts Receivable 5 0 0 0 00
Supplies 1 5 0 0 00
Prepaid Rent 8 0 0 0 00 Owner’s Equity
Equipment 11 0 0 0 00 Carolyn Wells, Capital 1 3 3 3 5 0 00
Total Assets 136 8 5 0 00 Total Liabilities and Owner’s Equity 1 3 6 8 5 0 00
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38 CHAPTER 2 Analyzing Business Transactions

MANAGERIAL IMPLICATIONS < <

ACCOUNTING SYSTEMS ■ Well-run and efficiently managed businesses have good accounting systems that
provide timely and useful information.
■ Sound financial records and statements are necessary so that businesspeople ■ Transactions involving revenue and expenses are recorded separately from
can make good decisions. owner’s equity in order to analyze operations for the period.
■ Financial statements show:
■ the amount of profit or loss,
THINKING CRITICALLY
■ the assets on hand,
If you were buying a business, what would you look for in the com-
pany’s financial statements?
■ the amount owed to creditors,

■ the amount of owner’s equity.

Net income from the income statement is used to prepare the statement of owner’s equity.
The ending capital balance from the statement of owner’s equity is used to prepare the balance
sheet.

The Importance of Financial Statements

Preparing financial statements is one of the accountant’s most important jobs. Each day mil-
lions of business decisions are made based on the information in financial statements.
Business managers and owners use the balance sheet and the income statement to control
current operations and plan for the future. Creditors, prospective investors, governmental
agencies, and others are interested in the profits of the business and in the asset and equity
structure.

Section 2 Self Review

QUESTIONS c. $160,000 c. revenue and expenses on a specific date
1. If an owner gives personal tools to the business, d. $110,000 d. revenues and expenses for a period of time
how is the transaction recorded? 5. Haden Hardware had revenues of $110,000 and
2. What information is included in the financial expenses of $52,000. How does this affect
owner’s equity? (Answers to Section 2 Self Review are on
statement headings? page 50.)
3. What are withdrawals and how do they affect the A N A LY S I S
basic accounting equation? 6. What information is contained in the income
EXERCISES statement?
4. Design Interiors has assets of $180,000 and lia- a. assets, liabilities, and owner’s equity on a
bilities of $70,000. What is the owner’s equity? specific date
a. $50,000 b. assets, liabilities, and owner’s equity for a
period of time
b. $30,000
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Analyzing Business Transactions CHAPTER 2 39

REVIEW Chapter Summary Chapter 2

Accounting begins with the analysis of business transactions. Each transaction changes the financial
position of a business. In this chapter, you have learned how to analyze business transactions and
how they affect assets, liabilities, and owner’s equity. After transactions are analyzed and recorded,
financial statements reflect the summarized changes to and results of business operations.

Review and Applications

Learning Objectives
Record in equation form the financial effects of For the income statement, “when” refers to a period
2-1 a business transaction. of time.
The equation property equals financial interest Prepare a statement of owner’s equity and a
reflects the fact that in a free enterprise system all 2-5 balance sheet.
property is owned by someone. This equation
Changes in owner’s equity for the period are
remains in balance after each business transaction.
summarized on the statement of owner’s equity.
Define, identify, and understand the relationship ■ Net income increases owner’s equity.
2-2 between asset, liability, and owner’s equity
■ Added investments increase owner’s equity.
accounts.
■ A net loss for the period decreases owner’s
The term assets refers to property. The terms
equity.
liabilities and owner’s equity refer to financial
interest. The relationship between assets, liabilities, ■ Withdrawals by the owner decrease owner’s

and owner’s equity is shown in equation form. equity.

Assets 5 Liabilities 1 Owner’s Equity A statement of owner’s equity has a three-line
heading:
Owner’s Equity 5 Assets 2 Liabilities
■ who
Liabilities 5 Assets 2 Owner’s Equity
■ what
Analyze the effects of business transactions
■ when
on a firm’s assets, liabilities, and owner’s
2-3 equity and record these effects in accounting For the statement of owner’s equity, “when” refers
equation form. to a period of time.
1. Describe the financial event. The balance sheet shows the assets, liabilities, and
owner’s equity on a given date.
■ Identify the property.
A balance sheet has a three-line heading:
■ Identify who owns the property.
■ who
■ Determine the amount of the increase or
decrease. ■ what

2. Make sure the equation is in balance. ■ when

For the balance sheet, “when” refers to a single

2-4 Prepare an income statement.
date.
The income statement summarizes changes in
The financial statements are prepared in the
owner’s equity that result from revenue and expenses.
following order.
The difference between revenue and expenses is the
net income or net loss of the business for the period. 1. Income Statement
An income statement has a three-line heading: 2. Statement of Owner’s Equity
■ who 3. Balance Sheet
■ what
2-6 Define the accounting terms new to this chapter.
■ when
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40 CHAPTER 2 Analyzing Business Transactions

Glossary
Accounts payable (p. 24) Amounts a business must pay in the future
Accounts receivable (p. 30) Claims for future collection from customers
Assets (p. 27) Property owned by a business
Balance sheet (p. 27) A formal report of a business’s financial condition on a certain date; reports
the assets, liabilities, and owner’s equity of the business
Break even (p. 34) A point at which revenue equals expenses
Business transaction (p. 22) A financial event that changes the resources of a firm
Capital (p. 23) Financial investment in a business; equity
Equity (p. 23) An owner’s financial interest in a business
Expense (p. 30) An outflow of cash, use of other assets, or incurring of a liability
Fair market value (p. 36) The current worth of an asset or the price the asset would bring if sold
on the open market
Fundamental accounting equation (p. 29) The relationship between assets and liabilities plus
owner’s equity
Income statement (p. 34) A formal report of business operations covering a specific period of
time; also called a profit and loss statement or a statement of income and expenses
Liabilities (p. 27) Debts or obligations of a business
Net income (p. 34) The result of an excess of revenue over expenses
Net loss (p. 34) The result of an excess of expenses over revenue
On account (p. 24) An arrangement to allow payment at a later date; also called a charge account
or open-account credit
Owner’s equity (p. 27) The financial interest of the owner of a business; also called proprietorship
or net worth
Revenue (p. 30) An inflow of money or other assets that results from the sales of goods or services
or from the use of money or property; also called income
Statement of owner’s equity (p. 35) A formal report of changes that occurred in the owner’s
financial interest during a reporting period
Withdrawals (p. 33) Funds taken from the business by the owner for personal use

Comprehensive Self Review

1. In what order are the financial statements prepared? Why?
2. What effect do revenue and expenses have on owner’s equity?
3. What is the difference between buying for cash and buying on account?
4. If one side of the fundamental accounting equation is decreased, what will happen to the other
side? Why?
5. Describe a transaction that will cause Accounts Payable and Cash to decrease by $1,200.
(Answers to Comprehensive Self Review are on page 51.)

Discussion Questions
1. What is the fundamental accounting equation?
2. What are assets, liabilities, and owner’s equity?
3. What information does the balance sheet contain?
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Analyzing Business Transactions CHAPTER 2 41

4. What information does the income statement contain?

5. What information does the statement of owner’s equity contain?
6. What information is shown in the heading of a financial statement?
7. Why does the third line of the headings differ on the balance
sheet and the income statement?
8. What is revenue?
9. What are expenses?
10. How is net income determined?
11. How does net income affect owner’s equity?
12. Describe the effects of each of the following business
transactions on assets, liabilities, and owner’s equity.
a. Bought equipment on credit.
b. Paid salaries to employees.
c. Sold services for cash.
d. Paid cash to a creditor.
e. Bought furniture for cash.
f. Sold services on credit.

APPLICATIONS
Exercises

▼
Determining accounting equation amounts. Exercise 2.1
Just before Walker Laboratories opened for business, James Walker, the owner, had the following Objectives 2-1, 2-2
assets and liabilities. Determine the totals that would appear in the firm’s fundamental accounting
equation (Assets 5 Liabilities 1 Owner’s Equity).

Cash $41,500
Laboratory Equipment 76,600
Laboratory Supplies 7,800
Loan Payable 16,100
Accounts Payable 10,125
▼

Completing the accounting equation. Exercise 2.2

The fundamental accounting equation for several businesses follows. Supply the missing amounts. Objectives 2-1, 2-2

Assets 5 Liabilities 1 Owner’s Equity

1. $27,800 5 $5,560 1 $ ?
2. $24,200 5 $5,180 1 $ ?
3. $16,075 5 $ ? 1 $10,400
4. $ ? 5 $4,400 1 $32,325
5. $34,000 5 $ ? 1 $25,125
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42 CHAPTER 2 Analyzing Business Transactions

Determining the effects of transactions on the accounting

▼
Exercise 2.3
Objectives 2-1, equation.
2-2, 2-3 Indicate the impact of each of the transactions below on the fundamental accounting equation
(Assets 5 Liabilities 1 Owner’s Equity) by placing a “1” to indicate an increase and a “2” to
indicate a decrease. The first transaction is entered as an example.

Assets 5 Liabilities 1 Owner’s Equity

Transaction 1 1 1

TRANSACTIONS
1. Owner invested $90,000 in the business.
2. Purchased $26,700 supplies on account.
3. Purchased equipment for $21,000 cash.
4. Paid $6,000 for rent (in advance).
5. Performed services for $7,800 cash.
6. Paid $2,160 for utilities.
7. Performed services for $10,500 on account.
8. Received $6,600 from charge account customers.
9. Paid salaries of $4,500 to employees.
10. Paid $6,000 to a creditor on account.
▼

Exercise 2.4 Determining balance sheet amounts.

Objectives 2-1, The following financial data are for the dental practice of Dr. David Malone when he began opera-
2-2, 2-3 tions in July. Determine the amounts that would appear in Dr. Malone’s balance sheet.
1. Owes $19,000 to the Davis Equipment Company.
2. Has cash balance of $13,500.
3. Has dental supplies of $3,650.
4. Owes $4,180 to 21st Century Furniture Supply.
5. Has dental equipment of $26,550.
6. Has office furniture of $8,000.
▼

Exercise 2.5 Determining the effects of transactions on the accounting

Objectives 2-1, equation.
2-2, 2-3 EZ Copy had the transactions listed below during the month of June. Show how each transaction
would be recorded in the accounting equation. Compute the totals at the end of the month. The
headings to be used in the equation follow.

Assets 5 Liabilities 1 Owner’s Equity

Accounts Accounts John Amos,
Cash 1 Receivable 1 Equipment 5 Payable 1 Capital 1 Revenue 2 Expenses

TRANSACTIONS
1. John Amos started the business with a cash investment of $60,000.
2. Purchased equipment for $22,000 on credit.
3. Performed services for $3,100 in cash.
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Analyzing Business Transactions CHAPTER 2 43

4. Purchased additional equipment for $4,600 in cash.

5. Performed services for $5,050 on credit.
6. Paid salaries of $4,450 to employees.
7. Received $3,200 cash from charge account customers.
8. Paid $13,000 to a creditor on account.

Computing net income or net loss.

▼
Exercise 2.6
Computer Maintenance and Repair Shop had the following revenue and expenses during the month
Objective 2-4
ended July 31. Did the firm earn a net income or incur a net loss for the period? What was the
amount?

Fees for computer repairs $44,600

Advertising expense 6,300
Salaries expense 19,100
Telephone expense 1,150
Fees for printer repairs 6,550
Utilities expense 1,600

Identifying transactions.

▼
Exercise 2.7
The following equation shows the effects of a number of transactions that took place at Beck Auto
Objectives 2-1,
Repair Company during the month of July. Describe each transaction.
2-2, 2-3

Assets 5 Liabilities 1 Owner’s Equity

Accounts Accounts Peter Beck,
Cash 1 Receivable 1 Equipment 5 Payable 1 Capital 1 Revenue 2 Expenses

Bal. $80,000 1 $6,000 1 $64,000 5 $38,000 1 $112,000 1 0 2 0

1. 110,000 1$10,000
2. 27,600 17,600
3. 23,800 23,800
4. 26,700 1$6,700
5. 11,500 2 1,500
6. 112,000 112,000
7. 24,100 14,100
▼

Preparing an income statement. Exercise 2.8

At the beginning of September, Alexandria Perez started Perez Investment Services, a firm that offers Objective 2-4
advice about investing and managing money. On September 30, the accounting records of the business
showed the following information. Prepare an income statement for the month of September 2016.
Cash $33,100 Fees Income $77,900
Accounts Receivable 4,000 Advertising Expense 6,500
Office Supplies 3,400 Salaries Expense 16,000
Office Equipment 37,500 Telephone Expense 800
Accounts Payable 5,700 Withdrawals 9,000
Alexandria Perez, Capital,
September 1, 2016 26,700
▼

Computing net income or net loss. Exercise 2.9

On December 1, Kate Holmes opened a speech and hearing clinic. During December, her firm had Objective 2-4
the following transactions involving revenue and expenses. Did the firm earn a net income or incur
a net loss for the period? What was the amount?
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44 CHAPTER 2 Analyzing Business Transactions

Paid $3,100 for advertising.

Provided services for $2,800 in cash.
Paid $800 for telephone service.
Paid salaries of $2,600 to employees.
Provided services for $3,000 on credit.
Paid $450 for office cleaning service.

Exercise 2.10 ▼ Preparing a statement of owner’s equity and a balance sheet.

Objective 2-5 Using the information provided in Exercise 2.8, prepare a statement of owner’s equity for the month
CONTINUING >>> of September and a balance sheet for Perez Investment Services as of September 30, 2016.
Problem

PROBLEMS
Problem Set A
▼

Problem 2.1A Analyzing the effects of transactions on the accounting equation.

Objectives 2-1, On July 1, Guy Fernandez established Fernandez Home Appraisal Services, a firm that provides
2-2, 2-3 expert residential appraisals and represents clients in home appraisal hearings.

INSTRUCTIONS
Analyze the following transactions. Record in equation form the changes that occur in assets, liabil-
ities, and owner’s equity. (Use plus, minus, and equals signs.)

TRANSACTIONS
1. The owner invested $97,000 in cash to begin the business.
2. Paid $19,750 in cash for the purchase of equipment.
3. Purchased additional equipment for $14,400 on credit.
4. Paid $11,800 in cash to creditors.
5. The owner made an additional investment of $30,000 in cash.
6. Performed services for $8,200 in cash.
7. Performed services for $6,300 on account.
8. Paid $4,000 for rent expense.
9. Received $3,500 in cash from credit clients.
10. Paid $6,460 in cash for office supplies.
11. The owner withdrew $9,000 in cash for personal expenses.
Analyze: What is the ending balance of cash after all transactions have been recorded?
▼

Problem 2.2A Analyzing the effects of transactions on the accounting equation.

Objectives 2-1, Maurice Dickey is a painting contractor who specializes in painting commercial buildings. At the
2-2, 2-3 beginning of June, his firm’s financial records showed the following assets, liabilities, and owner’s
equity.
Cash $61,000 Accounts Payable $11,200
Accounts Receivable 16,600 Maurice Dickey, Capital 91,500
Office Furniture 35,800 Revenue 58,600
Auto 23,500 Expenses 24,400

INSTRUCTIONS
Set up an accounting equation using the balances given above. Record the effects of the following trans-
actions in the equation. (Use plus, minus, and equals signs.) Record new balances after each transaction
has been entered. Prove the equality of the two sides of the final equation on a separate sheet of paper.
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Analyzing Business Transactions CHAPTER 2 45

TRANSACTIONS
1. Performed services for $6,680 on credit.
2. Paid $1,700 in cash for new office chairs.
3. Received $11,200 in cash from credit clients.
4. Paid $880 in cash for telephone service.
5. Sent a check for $4,500 in partial payment of the amount due
creditors.
6. Paid salaries of $9,700 in cash.
7. Sent a check for $1,120 to pay electric bill.
8. Performed services for $10,500 in cash.
9. Paid $2,350 in cash for auto repairs.
10. Performed services for $12,500 on account.
Analyze: What is the amount of total assets after all transactions have been recorded?

▼
Preparing a balance sheet. Problem 2.3A
Brown Equipment Repair Service is owned by James Brown. Objective 2-5
INSTRUCTIONS
Use the following figures to prepare a balance sheet dated February 29, 2016. (You will need to
compute the owner’s equity.)
Cash $34,300 Equipment $78,000
Supplies 6,380 Accounts Payable 24,000
Accounts Receivable 13,200
Analyze: What is the net worth, or owner’s equity, at February 29, 2016 for Brown Equipment
Repair Service?

▼
Preparing an income statement, a statement of owner’s equity, Problem 2.4A
and a balance sheet. Objectives 2-4, 2-5
The following equation shows the transactions of Cotton Cleaning Service during May. The busi-
ness is owned by Taylor Cotton.

Assets 5 Liab. 1 Owner’s Equity

Accts. Accts. T. Cotton,
Cash 1 Rec. 1 Supp. 1 Equip. 5 Pay. 1 Capital 1 Rev. 2 Exp.

Balances, May 1 15,000 1 3,000 1 5,800 1 33,800 5 7,000 1 50,600 1 0 2 0

Paid for utilities 2980 1980
–––––– –––––– ––––– ––––– –––––– –––––– –––––– ––––––
New balances 14,020 1 3,000 1 5,800 1 33,800 5 7,000 1 50,600 1 0 2 980
Sold services for cash 14,980 14,980
–––––– –––––– ––––– ––––– –––––– –––––– –––––– ––––––
New balances 19,000 1 3,000 1 5,800 1 33,800 5 7,000 1 50,600 1 4,980 2 980
Paid a creditor 22,100 22,100
–––––– –––––– ––––– ––––– –––––– –––––– –––––– ––––––
New balances 16,900 1 3,000 1 5,800 1 33,800 5 4,900 1 50,600 1 4,980 2 980
Sold services on credit 12,900 12,900
–––––– –––––– ––––– ––––– –––––– –––––– –––––– ––––––
New balances 16,900 1 5,900 1 5,800 1 33,800 5 4,900 1 50,600 1 7,880 2 980
Paid salaries 28,900 18,900
–––––– –––––– ––––– ––––– –––––– –––––– –––––– ––––––
New balances 8,000 1 5,900 1 5,800 1 33,800 5 4,900 1 50,600 1 7,880 2 9,880
Paid telephone bill 2314 1314
–––––– –––––– ––––– ––––– –––––– –––––– –––––– ––––––
New balances 7,686 1 5,900 1 5,800 1 33,800 5 4,900 1 50,600 1 7,880 2 10,194
Withdrew cash for
personal expenses 23,000 23,000
–––––– –––––– ––––– ––––– –––––– –––––– –––––– ––––––
New balances 4,686 1 5,900 1 5,800 1 33,800 5 4,900 1 47,600 1 7,880 2 10,194
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46 CHAPTER 2 Analyzing Business Transactions

INSTRUCTIONS
Analyze each transaction carefully. Prepare an income statement and a statement of owner’s equity
for the month. Prepare a balance sheet for May 31, 2016. List the expenses in detail on the income
statement.
Analyze: In order to complete the balance sheet, which amount was transferred from the statement
of owner’s equity?

▼ Problem Set B
Problem 2.1B Analyzing the effects of transactions on the accounting equation.
Objectives 2-1, On September 1, Rosa Escobedo opened Self Confidence Tutoring Service.
2-2, 2-3
INSTRUCTIONS
Analyze the following transactions. Use the fundamental accounting equation form to record the
changes in property, claims of creditors, and owner’s equity. (Use plus, minus, and equals signs.)
TRANSACTIONS
1. The owner invested $72,000 in cash to begin the business.
2. Purchased equipment for $32,000 in cash.
3. Purchased $12,000 of additional equipment on credit.
4. Paid $6,000 in cash to creditors.
5. The owner made an additional investment of $12,000 in cash.
6. Performed services for $8,400 in cash.
7. Performed services for $7,300 on account.
8. Paid $5,200 for rent expense.
9. Received $5,000 in cash from credit clients.
10. Paid $6,300 in cash for office supplies.
11. The owner withdrew $10,000 in cash for personal expenses.
Analyze: Which transactions increased the company’s debt? By what amount?
▼

Problem 2.2B Analyzing the effects of transactions on the accounting equation.

Objectives 2-1, Sherrye Cravens owns Cravens’s Consulting Service. At the beginning of September, her firm’s
2-2, 2-3 financial records showed the following assets, liabilities, and owner’s equity.
Cash $38,000 Accounts Payable $10,000
Accounts Receivable 12,000 Sherrye Cravens, Capital 49,800
Supplies 12,800 Revenue 52,000
Office Furniture 24,000 Expenses 25,000

INSTRUCTIONS
Set up an equation using the balances given above. Record the effects of the following transactions
in the equation. (Use plus, minus, and equals signs.) Record new balances after each transaction has
been entered. Prove the equality of the two sides of the final equation on a separate sheet of paper.
TRANSACTIONS
1. Performed services for $8,000 on credit.
2. Paid $2,880 in cash for utilities.
3. Performed services for $10,000 in cash.
4. Paid $1,600 in cash for office cleaning service.
5. Sent a check for $4,800 to a creditor.
6. Paid $1,920 in cash for the telephone bill.
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Analyzing Business Transactions CHAPTER 2 47

7. Issued checks for $14,000 to pay salaries.

8. Performed services for $11,200 in cash.
9. Purchased additional supplies for $2,000 on credit.
10. Received $6,000 in cash from credit clients.

Analyze: What is the ending balance for owner’s equity after all transactions have been recorded?

Preparing a balance sheet.

▼
Problem 2.3B
Douglas Smith is opening a tax preparation service on December 1, which will be called Smith’s Objective 2-5
Tax Service. Douglas plans to open the business by depositing $50,000 cash into a business check-
ing account. The following assets will also be owned by the business: furniture (fair market value of
$10,000) and computers and printers (fair market value of $12,000). There are no outstanding debts
of the business as it is formed.

INSTRUCTIONS
Prepare a balance sheet for December 1, 2016, for Smith’s Tax Service by entering the correct bal-
ances in the appropriate accounts. (You will need to use the accounting equation to compute
owner’s equity.)
Analyze: If Smith’s Tax Service had an outstanding debt of $16,000 when the business was
formed, what amount should be reported on the balance sheet for owner’s equity?

▼
Preparing an income statement, a statement of owner’s equity, Problem 2.4B
and a balance sheet. Objectives 2-4, 2-5
The equation below shows the transactions of Kathryn Proctor, Attorney and Counselor of Law,
during August. This law firm is owned by Kathryn Proctor.

Assets 5 Liab. 1 Owner’s Equity

Accts. Accts. K. Proctor,
Cash 1 Rec. 1 Supp. 1 Equip. 5 Pay. 1 Capital 1 Rev. 2 Exp.

Balances, Aug. 1 7,200 1,800 1 5,400 1 10,000 5 1,200 1 23,200 1 0 2 0

Paid for utilities 2600 ____ 1600
–––––– –––––– ––––– –––– –––––– –––––– ––––––
New balances 6,600 1 1,800 1 5,400 1 10,000 5 1,200 1 23,200 1 0 2 600
Performed services
for cash 16,000 ____ 16,000
–––––– –––––– ––––– –––– –––––– ––––––
New balances 12,600 1 1,800 1 5,400 1 10,000 5 1,200 1 23,200 1 6,000 2 600
Paid a creditor 2600 ____ 2600
–––––– –––––– ––––– –––– –––––– ––––––
New balances 12,000 1 1,800 1 5,400 1 10,000 5 600 1 23,200 1 6,000 2 600
Performed services
on credit 14,800
–––––– ____ 14,800
–––––– ––––– –––– –––––– –––––– ––––––
New balances 12,000 1 6,600 1 5,400 1 10,000 5 600 1 23,200 1 10,800 2 600
Paid salaries 25,400 ____ 15,400
–––––– –––––– ––––– –––– –––––– –––––– ––––––
New balances 6,600 1 6,600 1 5,400 1 10,000 5 600 1 23,200 1 10,800 2 6,000
Paid telephone bill 2600 ____ 1600
–––––– –––––– ––––– –––– –––––– –––––– ––––––
New balances 6,000 1 6,600 1 5,400 1 10,000 5 600 1 23,200 1 10,800 2 6,600
Withdrew cash for
personal expenses 21,200 21,200
–––––– –––––– ____ –––––– –––– –––––– –––––– ––––––
New balances 4,800 1 6,600 1 5,400 1 10,000 5 600 1 22,000 1 10,800 2 6,600
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48 CHAPTER 2 Analyzing Business Transactions

INSTRUCTIONS
Analyze each transaction carefully. Prepare an income statement and a statement of owner’s equity
for the month. Prepare a balance sheet for August 31, 2016. List the expenses in detail on the
income statement.
Analyze: In order to complete the statement of owner’s equity, which amount was transferred from
the income statement?

Critical Thinking Problem 2.1

Financial Statements
The following account balances are for Carl Nicholson, Certified Public Accountant, as of
April 30, 2016.
Cash $30,000
Accounts Receivable 12,000
Maintenance Expense 4,600
Advertising Expense 3,890
Fees Earned 26,800
Carl Nicholson, Capital, April 1 ?
Salaries Expense 13,000
Machinery 21,000
Accounts Payable 13,200
Carl Nicholson, Drawing 6,800

INSTRUCTIONS
Using the accounting equation form, determine the balance for Carl Nicholson, Capital, April 1,
2016. Prepare an income statement for the month of April, a statement of owner’s equity, and a bal-
ance sheet as of April 30, 2016. List the expenses on the income statement in alphabetical order.
Analyze: What net change in owner’s equity occurred during the month of April?

Critical Thinking Problem 2.2

Accounting for a New Company
James Mitchell opened a gym and fitness studio called Body Builders Fitness Center at the begin-
ning of November of the current year. It is now the end of December, and James is trying to deter-
mine whether he made a profit during his first two months of operations. You offer to help him and
ask to see his accounting records. He shows you a shoe box and tells you that every piece of paper
pertaining to the business is in that box.
As you go through the material in the shoe box, you discover the following:
a. A receipt from Clayton Properties for $8,000 for November’s rent on the exercise studio.
b. Bank deposit slips totaling $7,360 for money collected from customers who attended exercise
classes.
c. An invoice for $50,000 for exercise equipment. The first payment is not due until December 31.
d. A bill for $2,100 from the maintenance service that cleans the studio. James has not yet paid
this bill.
e. A December 19 parking ticket for $200. James says he was in a hurry that morning to get to
the Fitness Center on time and forgot to put money in the parking meter.
f. A handwritten list of customers and fees for the classes they have taken. As the customers attend the
classes, James writes their names and the amount of each customer’s fee on the list. As customers
pay, James crosses their names off the list. Fees not crossed off the list amount to $2,400.
g. A credit card receipt for $800 for printing flyers advertising the grand opening of the studio.
For convenience, James used his personal credit card.
h. A credit card receipt for $800 for four warm-up suits James bought to wear at the studio. He
also put this purchase on his personal credit card.
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Analyzing Business Transactions CHAPTER 2 49

Use the concepts you have learned in this chapter to help James.
1. Prepare an income statement for the first two months of operation of Body Builders Fitness Center.
2. How would you evaluate the results of the first two months of operation?
3. What advice would you give James concerning his system of accounting?

BUSINESS CONNECTIONS
Interpreting Results
1. After examining financial data for a monthly period, the owner of a small business expressed Managerial FOCUS
surprise that the firm’s cash balance had decreased during the month even though there was
substantial net income. Do you think this owner is right to expect cash to increase because of a
substantial net income? Why or why not?
2. Is it reasonable to expect that all new businesses will have a net income from the first month’s
operations? From the first year’s operations?
3. Why should managers be concerned with changes in the amount of creditors’ claims against
the business?
4. How does an accounting system help managers control operations and make sound decisions?

To Record or Not to Record

You are Julia, a new Accounts Receivable Clerk for Nixon Paper and Office Supply. Toward the end Ethical DILEMMA
of the month, Carol Reed, a very personable sales associate, tells you that the previous A/R clerk
always recorded a Sales Invoice when she got a verbal agreement from a customer to buy paper or
office supplies. She has a verbal order from her favorite customer for $10,000 of paper and wants
you to create a Sales Invoice today. You know that in order to create a Sales Invoice you need a pur-
chase order from the customer. You also know that Ms. Reed receives a monthly bonus based on the
monthly sales. If her sales are above $20,000, she gets a 10 percent bonus. Would you agree to
record the sales of products before receiving the purchase order from the customer? What effect
would it have on the customer, on the Sales Associate, on the company, and on the job?

Income Statement
Financial Statement
Review the following excerpt from the 2012 consolidated statement of income for Southwest Air- ANALYSIS
lines Co. Answer the questions that follow.

Southwest Airlines Co.

Consolidated Statement of Income
Years Ended December 31, 2010, 2011, and 2012

2012 2011 2010

Operating Revenues (in millions):
Passenger $16,093 $14,735 $11,489
Freight 160 139 125
Other 835 784 490
Total operating revenues 17,088 15,658 12,104

Net Income $421 $178 $459

Analyze:
1. Although the format for the heading of an income statement can vary from company to
company, the heading should contain the answers to who, what, and when. List the answers to
each question for the statement presented above.
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50 CHAPTER 2 Analyzing Business Transactions

2. What three types of revenue are reflected on this statement?

3. The net income of $421,000,000 reflected on Southwest Airlines Co.’s consolidated statement
of income for 2012 will be transferred to the next financial statement to be prepared. Net
income is needed to complete which statement?
Analyze Online: Find the Investor Relations section of the Southwest Airlines Co. website
(www.southwest.com) and answer the following questions.
4. What total operating revenues did Southwest Airlines Co. report for the most recent quarter?
5. Find the most recent press release posted on the website. Read the press release, and
summarize the topic discussed. What effect, if any, do you think this will have on company
earnings? Why?

Selling on Internet
Internet CONNECTION
Go to the Federated Corporation website at www.federated-fds.com. What companies are included
in this corporation? Can you see a link to purchase items on line? What transaction, if any, would
you record when an item is ordered from the Internet? Does the website include job offerings? What
jobs would be available in Finance (go to Support operations, finance to find the requirements for a
job)?

Working to Provide Accurate Data

TEAMWORK
Gloria’s Fabrics is a large fabric provider to the general public. The accounting office has three
employees: accounts receivable clerk, accounts payable clerk, and full charge bookkeeper. The
accounts receivable clerk creates the sales invoices and records the cash receipts, the accounts
payable clerk creates and pays the purchase orders, and the full charge bookkeeper reconciles the
checking account. Assign each group member one of the three jobs. Identify the accounts and
describe the transactions that would be recorded by that assigned job. What effect would each trans-
action have on each account? How would each member of the accounting department work together
to present accurate information for the decision makers?

Answers to Self Reviews

Answers to Section 1 Self Review
1. An example is the initial investment of cash in a business by the owner.
2. Amounts that a company must pay to creditors in the future.
3. A financial event that changes the resources of the firm.
4. d. $150,000
5. a. Equipment is increased by $2,950 and accounts payable is increased by $2,950.
6. $20,000

Answers to Section 2 Self Review

1. As an additional investment by the owner recorded on the basis of fair market value.
2. The firm’s name (who), the title of the statement (what), and the time period covered by the
report (when).
3. Funds taken from the business to pay for personal expenses. They decrease the owner’s equity
in the business.
4. d. $110,000
5. $58,000 increase
6. d. revenue and expenses for a period of time
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Analyzing Business Transactions CHAPTER 2 51

Answers to Comprehensive Self Review

1. The income statement is prepared first because the net income or loss is needed to complete
the statement of owner’s equity. The statement of owner’s equity is prepared next to update the
change in owner’s equity. The balance sheet is prepared last.
2. Revenue increases owner’s equity. Expenses decrease owner’s equity.
3. Buying for cash results in an immediate decrease in cash; buying on account results in a
liability recorded as accounts payable.
4. The opposite side of the accounting equation will decrease because a decrease in assets results
in a corresponding decrease in either a liability or the owner’s equity.
5. The payment of $1,200 to a creditor on account.
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