Part 2 Establishing a Business and the Balance Sheet

LEARNING OBJECTIVES

• LO1 Identify what constitutes a business transaction and recognise common balance sheet account titles used in business.
• LO2 Apply transaction analysis to simple business transactions in terms of the accounting model: Assets = Liabilities + Owner’s Equity.
• LO3 Determine the impact of business transactions on the balance sheet using two basic tools, journal entries and T-accounts.
• LO4 prepare a simple classified balance sheet.

Determine the effects of business activities

Nature of Business Transactions

Business activities that affect the accounting equation are called transactions.

Transactions include two types of activities or events, external events and internal events.

External events are measurable exchanges between the business and others – exchanges of assets and services from one entity for other assets or promises to pay from another entity. Businesses undertake these exchanges either to bring in profits or to acquire resources with the potential to bring in profits. In other words, businesses create value through exchanges.

1. Receiving a cash investment in exchange for an ownership stake in the business
2. Borrowing cash from banks
3. Acquiring supplement
4. Selling goods and services to customers in exchange for their cash payments or promises to pay.

Internal events include certain events that are not exchanges between the business and others but nevertheless have a direct and measurable effect on the entity. Examples include the use of supplies and the use of a building over time.

Balance Sheet Accounts

Once a transaction has been identified, names must be given to the items that have been exchanged. Companies use a standardised format called an account that is an individual record of both increases and decreases in a specific asset, liability, owner’s equity, revenue, or expense. Each company establishes a chart of accounts – a list of all account title and their numbers that are unique to each company.

These accounts are usually organised by financial statement element with asset accounts listed first (the 100 series) followed by liabilities (the 200 series) and owner’s equity (the 300 series).

If you recognise some key words in an account title, you can tell what type of account it is.

• Accounts with receivable in the title are always assets; they represent amounts owed to the business by (receivable from) customers and others.
• Accounts with payable in the title are always liabilities; they represent amounts owed by the company to others to be paid in the future.
• Any account with prepaid in the title is an asset because it represents amounts paid to others for future benefits, such as insurance coverage and property rentals.
• Accounts with unearned in the title are always liabilities that represent amounts paid to the company in the past by others who expect to receive goods or services from the company in the future.

Transaction Analysis

Transaction analysis is the process of studying a transaction and its related documents to determine their effect on the business in terms of the accounting equation. Documents (also called source documents) are the sources of evidence that a business activity has occurred. Source documents include, for example, sales receipts, checks, invoices (bills) from suppliers, cash register tapes, and employee time cards.

There are two rules to follow in performing transaction analysis:

• Dual effects: every transaction affects at least two accounts. It is critical that you correctly identify those accounts and the direction of the effect (whether an increase or a decrease). This is what accountants have developed into a system known as double-entry bookkeeping.
• Balancing the accounting equation: The accounting equation must remain in balance after each transaction is recorded.

Dual Effects

Every transaction has at least two effects on the basic accounting equation. Transactions with external parties involve an exchange through which the business entity both receives something and gives something else up.

Balancing the Accounting Equation

The accounting equation must remain in balance after each transaction. That is, total assets (resource) must equal total liabilities and owner’s equity (claims to resources). If all of the correct accounts have been identified and the appropriate direction of the effect on each account has been determined, the equation should remain in balance.

Prepare accounting records

The Accounting Cycle

For most organisations, however, recording the transaction effects and keeping track of account balances is impractical. To process the many transactions that businesses generate every day, most companies establish computerised accounting systems. These systems follow a cycle, called the accounting cycle.

There are three steps during the period:

1. Analyse transactions that result in exchanges between the company and external parties.
2. Record the effects in chronological order in the first accounting book, called the general journal.
3. Post (transfer) each effect in the general journal to a specific page in another accounting book, called the general ledger, in which each page represents a separate account.

Analysing Business Transactions

Remember two important points about this model:

First and most important, the direction of the effect on a T-account depends on which side of the accounting equation’s equal sign you are:

• Because assets are shown on the left side of the equal sign in the accounting equation, an increase (+) is shown on the left side of the T-account.
• Because liabilities and owner’s equity are shown on the right side of the equal sign in the accounting equation, an increase (+) is shown on the right side of the T-account.

The second important point to remember is that there are special accounting names for the left and right sides of the accounts:

• Debit is on the left. So, asset accounts that are on the left side of the equal sign in the accounting equation generally have debit balances. It is highly unusual for an asset account such as Inventory to have a negative (credit) balance.
• Credit is on the right. So, liability and owner’s equity accounts that are on the right side of the equal sign in the accounting equation generally have credit balances.

If you have identified the correct accounts and effects through transaction analysis, the accounting equation will remain in balance. Moreover, in any transaction, the total dollar value of all debits must equal the total dollar value of all credits. For an extra measure of assurance, add this equality check (Debits = Credits) to the transaction analysis process.

Recording Transaction Effects

After reviewing the business documents that support a transaction, the bookkeeper analyses the effects of the transaction on the accounts and then enters them in the journal in chronological order, using a special form called the journal entry.

The journal entry is an accounting tool for expressing the effects of a transaction on the accounts. It is written in a debits-equal-credits format.

Posting Transaction Effects

Journal entries show the effects of transactions, but they do not provide account balances. That is why the second book, the general ledger, is necessary.

Each page in the ledger represents an account. After the journal entries have been recorded, the bookkeeper posts (transfers) the dollar amounts to each ledger page that the transaction affected so that the account balances can be computed.

The ledger page number (that is, the account number) is then entered in the reference column in the journal, and the journal page number is entered in the reference column in the ledger.

In most computerised accounting system, these cross-references are entered automatically. In the manual accounting system that some small organisations still use, the ledger is often a three-ring binder with a separate page for each account.