3 - Chapter 3 Notes - Changes in Financial Position

CHAPTER 3 - ANALYZING CHANGES IN FINANCIAL POSITION

Section 3.1 - Business Transactions

A business transaction is a financial event that causes a change in a company’s financial position (A = L + OE).

In other words, a business transaction is an event that causes a change in the value (balance) of a company’s asset, liability or equity accounts.

Two of the most common examples of business transactions are

(a) the cash purchase or cash sale of goods or services  

     Cash purchase = buy now, pay now

     Cash sale = sell now, collect payment now

(b) the purchase or sale of goods or services on credit/on account

     Purchase on credit/on account = buy now, pay later (Accounts Payable)

     Sale on credit/on account = sell now, collect/receive payment later (Accounts Receivable)

For a purchase on account, two transactions are actually involved: buy now (transaction #1) and then pay later (transaction #2). 

Similiarly, for a sale on account, two transactions are actually involved: sell now (transaction #1) and then collect/receive payment later (transaction #2). 

That said, when a business owner purchases an item for personal use or a customer merely thinks about purchasing an item but ultimately chooses not to, the financial position of the business is not affected and so a business transaction has not occurred.

You may have noticed that when one of the accounts of a business is affected by a business transaction, at least one other account must also be affected. Why is this so? This is because the fundamental accounting equation (A = L + OE) must remain true at all times, including after each transaction.

Accordingly, perhaps it is even more accurate to state that a business transaction is a financial event that affects (changes) the values (balances) of at least two accounts of the business so that the equation A = L + OE remains true.

Section 3.2 - Equation Analysis Sheet (EAS)

As multiple business transactions take place daily, the values of certain asset, liability and owner's equity accounts will increase or decrease accordingly.

These daily changes in value are not recorded on the balance sheet, however, as to do so would be very time-consuming and inconvenient indeed.

Instead, for now these changes will be recorded on an informal (and unofficial) business document known as an Equation Analysis Sheet (EAS) which is a much more efficient means of recording changes to the values of various accounts as a result of business transactions.

An example of an EAS is found in the next document on your Chapter 3 Content list entitled "ch 3 EAS example."

The beginning or opening balance in each account on the EAS is taken from the most recently prepared balance sheet. Notice how each account on the EAS is listed in the same order, left to right, as typically found on the balance sheet under the subheadings of assets, liabilities and owner's equity.

Thereafter, notice how each transaction is recorded separately on the Transaction line before updated balances for each account are calculated on the New Balances line.  

Looking at the "ch 3 EAS example":

Transaction #1 involves a $700 payment towards the company's outstanding mortgage.

Transaction #2 involves the receipt of a $527 payment from debtor customer P. O'Neil.

Transaction #3 involves a $300 cash purchase of equipment.

Now try to determine what must have happened in transactions #4 to #10 to bring about the changes to the various accounts that you can see in the "ch 3 EAS example."

And most importantly, notice how each transaction affects or changes at least two accounts on the EAS. Once again, this is to ensure that the fundamental accounting equation (A=L+OE) remains true after each transaction.

Finally, notice how assets, liabilities and owner's equity are totalled at the bottom of the EAS once all business transactions have been recorded in order to once again ensure that the fundamental accounting equation (A = L + OE) remains true.

Analyzing Transactions using the Equation Analysis Sheet

Don't forget that for each business transaction:

• • two account values (A, L, OE) must always change (increase or decrease), except for a few select transactions where three account values will change, namely extraordinary transactions (see below) and purchases involving partial down-payments (pay something now, pay remainder later) *

  • at least one asset value must always change and sometimes two asset values will change, except for one particular type of transaction where none of the assets are involved (see below) *

  • an asset value only changes when the business owns more or less of that asset

  • a liability value only changes when the business owes more or less money to its creditors

  • the value of capital (the sole equity account for now) only changes when the overall value of the business increases or decreases

  • generally speaking, equity/capital increases (business value increases) when: goods or services are sold for cash (sell now, collect now) or on account (sell now, collect later) in the ordinary course of operations, the owner invests cash or another asset into the business, or a company asset is sold for a gain in an extraordinary transaction

  • generally speaking, equity/capital decreases (business value decreases) when: the company pays for ordinary business costs or a bill is received for same but not yet paid, the owner withdraws cash or another asset from the business, or a company asset is sold for a loss in an extraordinary transaction

Click here for the online version of your homework exercises.

General Tips for Analyzing Transactions using the Equation Analysis Sheet

For each business transaction:

• always start with the assets to determine which accounts will change, then move onto the liabilities if necessary, and then look at equity (capital) if necessary

• the dollar changes to the left side (assets) of the equation must be exactly the same as the dollar changes to the right side of the equation (liabilities and equity), regardless of how many account values change

• remember that as of right now equity is only represented by the capital account, but in Chapter Five the concept of equity will be expanded to include capital, revenues, expenses and owner's drawings (CRED)

• there are exactly 12 different types of transactions that you will see in this class - 10 involve two account value changes while two involve three account value changes

• furthermore, of the 12 different types of transactions that you will see in this class, 11 involve at least one change to an asset value while one does not involve any change to an asset value

Summary of Transactions Affecting the Capital Account

The Capital account (the sole equity account for now) is only affected (increased or decreased) when one of the following business transactions takes place:

(1) goods or services are sold by the business to its customers (hint: revenues) in the ordinary course of operations (whether for cash or on account)

e.g. goods or services sold for cash -- Cash (increase) -- Capital (increase)

e.g. goods or services sold on credit/on account -- A/R (increase) -- Capital (increase)

(2) money is paid out or a bill is received (hint: expenses) concerning ordinary/routine business costs (e.g., rent, advertising, wages)

e.g. paid wages to company employees -- Capital (decrease) -- Cash (decrease)

e.g. received bill from Toronto Star re: September advertising -- Capital (decrease) -- A/P - Toronto Star (increase)*

*(the only exception to the rule that states at least one asset must always change in each business transaction)

(3) money or other assets are withdrawn (hint: drawings) from the business by the owner

e.g. owner withdraws cash from the business -- Capital (decrease) -- Cash (decrease)

(4) money or other assets are invested into the business by the owner (hint: still Capital)

e.g. owner invests personal vehicle into the business -- Automobile (increase) -- Capital (increase)

(5) a business asset (e.g., automobile, equipment, furniture) is sold for a gain or a loss in an extraordinary transaction, i.e., not in the ordinary course of operations (hint: still Capital)

e.g. company vehicle listed at $6000 sold at a loss for $4000 

-- Cash (increase $4000) -- Capital (decrease $2000) -- Automobile (decrease $6000)

e.g. company equipment listed at $8000 sold at a gain for $9000 

-- Cash (increase $9000) -- Equipment (decrease $8000) -- Capital (increase $1000)

Notice how each of the above transactions affects the overall value of the business - that is why the Capital account must be increased or decreased in each scenario. 

You may also notice that an increase to Capital corresponds with an overall increase to the value of the business. Conversely, a decrease to Capital corresponds with an overall decrease to the value of the business.

And please note that later on in this course, once we have learned about revenue, expense and drawings accounts and ultimately debit/credit theory and the double-entry system of accounting, this lesson will become much clearer in terms of understanding the concept of equity.

Section 3.3 - Introduction to Source Documents

In the real world of commerce, bookkeepers must record tens or hundreds or thousands of business transactions every day. But unlike in this class, bookkeepers do not learn of those transactions via sentences found in textbooks or exercises, like the following: The regular monthly employee wages of $3,000 are paid in cash. 

Instead, bookkeepers typically learn of business transactions via source documents.

A source document is a tiny piece of paper (or an electronic version thereof) evidencing a business transaction. It is the original record of the financial event used by the accounting department to record the transaction in the company’s books.

More specifically, a source document provides the accounting department with all of the information necessary to record the specific accounts and dollar amounts involved in each transaction.

Most source documents represent proof of purchase and/or payment.

Common examples of source documents include bills, receipts, invoices, cheque copies or stubs, cash register tapes and credit card slips.

Proper source documents should contain the following information: date of transaction, parties (buyer/seller) to transaction, description of items sold/services provided, sale price including sales taxes, and terms of sale (payment due date if sale is made on account).