How Are Business Transactions and Financial Statements Related to the Accounting Equation?

Investors, lenders and managers rely on published financial statements to evaluate company performance and make decisions. Investors decide which companies to put their money into. Lenders determine which companies will repay their loans. Managers consider future strategic actions of the business. The accounting staff creates the financial statements by recording each transaction in the accounting records. Every business transaction is recorded based on the accounting equation.

1. Accounting Equation
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All business transactions build on the basic accounting equation. The accounting equation proclaims that the total of all assets owned by the company equals the total of all liabilities owed and all equity accounts. Every account used by a business falls into one of five categories. These categories include assets, liabilities, equity accounts, revenues and expenses. Revenues and expenses impact the retained earnings, an equity account. Revenues increase retained earnings whereas expenses decrease retained earnings.

Account Classification
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An accountant needs to classify each account according to its impact on a company's finances. Each account classified as an asset represents an item owned by a company. Assets include production equipment, inventory or copyrights. Each account classified as a liability represents a debt owed by the company to another person or entity. Liabilities include a mortgage payable or unearned rent. Each account classified as an equity account contributes to the net worth of the company. Equity accounts include retained earnings or common stock. Each account classified as revenue represents money earned by the company. Examples of revenue include sales or fees earned. Each account classified as an expense refers to costs incurred through the operation of the business. Examples of expenses include wages and utilities.

Transaction Recording
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As an accountant records each business transaction, she first determines what type of accounts to use and what dollar amounts to record. Each transaction affects at least two accounts. For example, when a business sells a product to a customer, it records an increase in sales and an increase in cash. Cash represents an asset, and sales refers to revenue. If a company borrows money, it records an increase in

cash and an increase in bank loan payable. Bank loan payable represents a liability.

Financial Statements
After an accountant records all the transactions for a month, he prepares to create financial statements. Each dollar amount recorded rests in a particular account. The financial statements build on the accounting equation using the account classification assigned. The income statement includes all accounts classified as revenues and expenses. This statement calculates the net income for the period. The balance sheet includes all assets, liabilities and equity accounts and follows the format of the accounting equation. The retained earnings account that appears on a balance sheet includes the net income reported on the income statement.

Relationship between Financial Statements

Explanation
Financial Statements reflect the effects of business transactions and events on the entity. The different types of financial statements are not isolated from one another but are closely related to one another as is illustrated in the following diagram.

Balance Sheet
Balance Sheet, or Statement of Financial Position, is directly related to the income statement, cash flow statement and statement of changes in equity. Assets, liabilities and equity balances reported in the Balance Sheet at the period end consist of:

Balances at the start of the period; The increase (or decrease) in net assets as a result of the net profit (or loss) reported in the income statement; The increase (or decrease) in net assets as a result of the net gains (or losses) recognized outside the income statement and directly in the statement of changes in equity (e.g. revaluation surplus); The increase in net assets and equity arising from the issue of share capital as reported in the statement of changes in equity; The decrease in net assets and equity arising from the payment of dividends as presented in the statement of changes in equity; The change in composition of balances arising from inter balance sheet transactions not included above (e.g. purchase of fixed assets, receipt of bank loan, etc). Accruals and Prepayments Receivables and Payables

Income Statement
Income Statement, or Profit and Loss Statement, is directly linked to balance sheet, cash flow statement and statement of changes in equity. The increase or decrease in net assets of an entity arising from the profit or loss reported in the income statement is incorporated in the balances reported in the balance sheet at the period end. The profit and loss recognized in income statement is included in the cash flow statement under the segment of cash flows from operation after adjustment of non-cash transactions. Net profit or loss during the year is also presented in the statement of changes in equity.

Statement of Changes in Equity

Statement of Changes in Equity is directly related to balance sheet and income statement. Statement of changes in equity shows the movement in equity reserves as reported in the entity's balance sheet at the start of the period and the end of the period. The statement therefore includes the change in equity reserves arising from share capital issues and redemptions, the payments of dividends, net profit or loss reported in the income statement along with any gains or losses recognized directly in equity (e.g. revaluation surplus).

Cash Flow Statement

Statement of Cash Flows is primarily linked to balance sheet as it explains the effects of change in cash and cash equivalents balance at the beginning and end of the reporting period in terms of the cash flow impact of changes in the components of balance sheet including assets, liabilities and equity reserves. Cash flow statement therefore reflects the increase or decrease in cash flow arising from:

Change in share capital reserves arising from share capital issues and redemption; Change in retained earnings as a result of net profit or loss recognized in the income statement (after adjusting non-cash items) and dividend payments; Change in long term loans due to receipt or repayment of loans; Working capital changes as reflected in the increase or decrease in net current assets recognized in the balance sheet; Change in non current assets due to receipts and payments upon the acquisitions and disposals of assets (i.e. investing activities)

Basic Financial Statements

The accounting process Financial Statements The Accounting Equation Chart of Accounts

Chapter 2 introduces you to the basic financial statements used to communicate a company's financial information to outsiders - parties other than the company's directors and managers, who are the "insiders."

What is a financial statement? What does it tell us? Why should we care? T hese are good questions and they deserve an answer. A business is a financial entity separate from its owners. Each business must keep financial records. A number of federal and state laws require this. But even if there were no laws, it would still be a good idea anyway. Businesses provide vital goods and services to those living in the community. They provide jobs for people, and tax dollars that improve our roads, parks and schools. It is in everyone's best interest that our community's businesses be successful. Business owners take a risk. What if no one wants to buy their goods or services? The owner has spent time and money to start a business, purchased land, buildings and equipment, hired people to work in the business.... all this done with the hope that the business will be successful. And if the business is NOT a success, the owner may have lost his or her life's savings, workers must find jobs, and creditors may go unpaid. Financial information may not make a business successful, but it helps the owner make sound business decisions. It can also help a bank or creditor evaluate the company for a loan or charge account. And the IRS will be interested in collecting the appropriate amount of income tax. So financial information will serve many purposes. Financial information comes in many forms, but the most important are the Financial Statements. They summarize relevant financial information in a format that is useful in making important business decisions. If this were not possible, the whole process would be a waste of time. Too much information may be equally useless. Financial statements summarize a large number of Transactions into a small number of significant categories. To be useful, information must be organized.

Financial statements have generally agreed-upon formats and follow the same rules of disclosure. This puts everyone on the same level playing field, and makes it possible to compare different companies with each other, or to evaluate different year's performance within the same company. There are three main financial statements:
1. Income Statement 2. Balance Sheet 3. Statement of Cash Flows Each financial statement tells it's own story. Together they form a comprehensive financial picture of the company, the results of its operations, its financial condition, and the sources and uses of its money. Evaluating past performance helps managers identify successful strategies, eliminate wasteful spending and budget appropriately for the future. Armed with this information they will be able to make necessary business decisions in a timely manner.

The accounting process in a nutshell:

1) Capture and Record a business transaction, 2) Classify the transaction into appropriate Accounts, 3) Post transactions to their individual Ledger Accounts, 4) Summarize and Report the balances of Ledger Accounts in financial statements.

There are 5 types of Accounts. 1) Assets 2) Liabilities 3) Owners' Equity (Stockholders' Equity for a corporation) 4) Revenues 5) Expenses All the accounts in an accounting system are listed in a Chart of Accounts. They are listed in the order shown above. This helps us prepare financial statements, by conveniently organizing accounts in the same order they will be used in the financial statements.

Financial Statements
The Balance Sheet lists the balances in all Asset, Liability and Owners' Equity accounts.

The Income Statement lists the balances in all Revenue and Expense accounts. The Balance Sheet and Income Statement must accompany each other in order to comply with GAAP. Financial statements presented separately do not comply with GAAP. This is necessary so financial statement users get a true and complete financial picture of the company.

All accounts are used in one or the other statement, but not both. All accounts are used once, and only once, in the financial statements. The Balance Sheet shows account balances at a particular date. The Income Statement shows the accumulation in the Revenue and Expense accounts, for a given period of time, generally one year. The Income Statement can be prepared for any span of time, and companies often prepare them monthly or quarterly. It is common for companies to prepare a Statement of Retained Earnings or a Statement of Owners' Equity, but one of these statement is not required by GAAP. These statements provide a link between the Income Statement and the Balance Sheet. They also reconcile the Owners' Equity or Retained Earnings account from the start to the end of the year.

The Statement of Cash Flows is the third financial statement required by GAAP, for full disclosure. The Cash Flow statement shows the inflows and outflows of Cash over a period of time, usually one year. The time period will coincide with the Income Statement. In fact, account balances are not used in the Cash Flow statement. The accounts are analyzed to determine the Sources (inflows) and Uses (outflows) of cash over a period of time. There are 3 types of cash flow (CF): 1) Operating - CF generated by normal business operations 2) Investing - CF from buying/selling assets: buildings, real estate, investment portfolios, equipment. 3) Financing - CF from investors or long-term creditors The SEC (Securities and Exchange Commission) requires companies to follow GAAP in their financial statements. That doesn't mean companies do what they are supposed to do. Enron executives had millions of reasons ($$) to falsify financial information for their own personal gain. Auditors are independent CPAs hired by companies to determine whether the rules of GAAP and full disclosure are being followed in their financial statements. In the case of Enron and Arthur Andersen, auditors sometimes fail to find problems that exist, and in some cases might have also failed in their responsibilities as accounting professionals.

Financial statements
Four financial statements are widely used: the balance sheet, the income statement, the cash flow statement and the statement of retained earnings. In this section, the main characteristics of each financial statement are discussed and a simple worksheet to record changes to the balance sheet is explained. Also, the relations between the statements are highlighted.

The balance sheet

The balance sheet shows the financial position of the firm at a point in time. The left side of the balance sheet (called the debit side) shows the resources of the company (assets), whereas on the right side (or, credit side), it shows how these resources have been funded. By definition, the funding is either by the owners (equity) or by others (liabilities). Asset: economic resources (with future value), or, things worth money. Liability: an obligation resulting from a past transaction to pay money, render services, or deliver goods. Equity: funding by the owners, or 'residual claim' (to the assets), which always equals total assets minus total liabilities. Example balance sheet

The assets of the fictitous company ABCD Inc. (which is also used later) on January 31st, 20X0 consist of cash and equipment, 41,500 in total. This amount has been funded with 400 liabilities, and 41,100 equity. The equity consists of 40,000 paid-in capital, which is the amount of money raised by issuing shares. Retained earnings of 1,100 is the total of profits that have not (yet) been paid out as dividend. For corporations the amount raised by issuing shares is presented separately from the profits retained in the company. For sole proprietorships - a business owned and ran by a single individual with no separate legal entity for the business - paid-in capital and retained earnings are not shown separately. Instead, these items are added and labeled 'capital'.

Liabilities and equity are a means to attract capital for funding of assets. More debt or equity means that the firm can buy more assets. Conversely, paying accounts payable, repaying a loan, buying back shares or paying out a dividend decreases the assets. The optimal amount of debt and equity, as well as the optimal mix between the two is outside the domain of financial accounting. Since the balance sheet shows the assets and the funding of the assets (liabilities and equity) at a point in time, it is not possible to infer the performance of the firm from the balance sheet. This is because performance is measured over a period. The income statement and the cash flow statement are used for this purpose (discussed later).
The accounting equation

The accounting equation (Assets = Liabilities + Equity) tells us that the balance sheet is balanced by definition, as all assets will be financed either by the owners themselves (equity) or by other people (liabilities). Since assets are presented on the debit side of the balance sheet and liabilities and equity on the credit side, the accounting equation implies the fundamental equation in accounting that total debits should equal total credits at all times. It is important to know that the accounting process is governed by accounting principles that sometimes are very binding and sometimes provide some flexibility. Well known principles include International Financial Reporting Standards (IFRS) and U.S. GAAP (Generally Accepted Accounting Principles). Sometimes economic assets are not allowed to be recognized as accounting assets by accounting principles. In other words: some assets may not be on the balance sheet. This generally is the case when it is difficult to determine the value of the asset. Further reading: Additional reading on accounting principles. In general, application of accounting principles results in the situation where the book value of assets (and equity) is below the market value of assets (and equity), since book assets are usually understated. This difference is expressed by the market-to-book ratio (dividing the market value of equity by the book value of equity). Further reading: Additional reading on the market-to-book ratio.

Analyzing Accounting Transactions

Guest Author - Consuelo Herrera, CAMS, CFE When the accounting process is complete a set of financial statements is issued. Financial statements are crucial for investment decisions, tax assessments, conflicts resolution, etc. The accounting process involves five steps: 1) Analyzing 2) Classifying 3) Recording 4) Summarizing 5) Interpreting Although all these steps are very important, analyzing a transaction grants reliance and relevance to the financial information. To be useful, accounting information must be both reliable and relevant. Decision-makers seek valuable information in which they can rely on when making informed decisions. When analyzing transactions the following questions should be posted and answered: 1) What are the accounts involved in a transaction? 2) What are the classifications of the accounts involved? Are they Assets, Liabilities, Owners Equity, Revenue, or Expense accounts? 3) Are the accounts increased? 4) Are the accounts decreased? Forensic accountants must be proficient in making inferences about accounting transactions. For example, if a forensic accountant is hired to help solve a dispute between two stockholders of a corporation, he or she will analyze the business transactions of the entity, establishing meaningful relationships among different accounts. From this initial input the accountant will have a road to other sources of information that validates his or her initial findings. Business transactions are events that have a direct economic impact on an entity and are expressed in terms of money. When confronted with a set of business transactions, we look for the impact they have on the stockholders equity. Each share of stock has certain rights and privileges spelled out when the shares are issued. The forensic accountant analyzing information will examine the articles of incorporation, stocks certificates, and laws and regulations. The following are the rights that each share carries, unless differently stated in corporate documents:

o To share proportionately in profits and losses o To share proportionately in management o To share proportionately in corporate assets upon liquidation. When analyzing Enron transactions, forensic accountants determined that Enron issued shares of common stock to special purpose entities, SPEs in exchange for notes receivables. This practice was deceitful to investors, creditors, and suppliers. The impact of recording those notes was an increase on the accounting assets when the following entry was made: Notes Receivable $ xxxx Stockholders Equity $xxxx The Securities and Exchange Commission, SEC, emphasized that it was an accounting error since equity cannot be recorded until cash is collected. Those analyzing these transactions had different points of view about the presentation of those accounts receivables. The SEC settled that issue by requiring this type of transaction to be recorded as a contra-equity account, a deduction from stockholders equity. Properly analyzing transactions prevents the issuance of misleading financial statements and increase reliance on financial information and helps re-gain trust in the accounting profession.
Key points: - the balance sheet shows the financial position at a point in time (a financial snapshot) - the accounting equation states that the value of the resources (assets) always equals total funding of these assets (liabilities and equity) - it is not possible to infer a firms profitability from (the) balance sheet(s) - assets are usually understated relative to the market value, whereas liabilities are not (or to a lesser extent), as a result, equity is usually understated (as equity is defined as the difference between the understated assets and total liabilities)

Using the accounting equation to record transactions

The method to record transactions described in this section is based on the accounting equation. Hence, it only keeps track of items on the balance sheet. This method is extended in the next lesson double entry bookkeeping, where also changes over time are recorded.
The accounting equation for transactions

The accounting equation states that all assets are funded by either the owners (equity) or others (liabilities): Assets = Liabilities + Equity.

The accounting equation refers to the balance sheet, where assets are shown on the debit side and the funding (liabilities and equity) on the credit side. If the accounting equation holds for the balance sheet at a point in time, it must hold for the beginning of period balance sheet as well as the end of period balance sheet. It then logically follows the accounting equation must also hold for changes; i.e., for each transaction the change in assets must equal the change in liabilities plus the change in equity: Assets = Liabilities + Equity.

Connecting the Income Statement and Balance Sheet

By John A. Tracy, CPA from Accounting Workbook For Dummies When an accountant records a sale or expense entry using double-entry accounting, he or she sees the interconnections between the income statement and balance sheet. A sale increases an asset or decreases a liability, and an expense decreases an asset or increases a liability. Therefore, one side of every sales and expense entry is in the income statement, and the other side is in the balance sheet. You cant record a sale or an expense without affecting the balance sheet. The income statement and balance sheet are inseparable, but they arent reported this way! To properly interpret financial statements, you need to understand the links between the statements, but the links arent easy to see. Each financial statement appears on a separate page in the annual financial report, and the threads of connection between the financial statements arent referred to. The following figure shows the lines of connection between income statement accounts and balance sheet accounts. When reading financial statements, in your minds eye, you should see these lines of connection. Because financial reports dont offer a clue about these connections, it may help to actually draw the lines of connection, like you would if you were highlighting lines in a textbook.

Connections between income statement and balance sheet accounts. Heres a quick summary explaining the lines of connection in the figure, starting from the top and working down to the bottom:

Making sales (and incurring expenses for making sales) requires a business to maintain a working cash balance. Making sales on credit generates accounts receivable. Selling products requires the business to carry an inventory (stock) of products. Acquiring products involves purchases on credit that generate accounts payable. Depreciation expense is recorded for the use of fixed assets (long-term operating resources). Depreciation is recorded in the accumulated depreciation contra account (instead decreasing the fixed asset account). Amortization expense is recorded for limited-life intangible assets. Operating expenses is a broad category of costs encompassing selling, administrative, and general expenses: o Some of these operating costs are prepaid before the expense is recorded, and until the expense is recorded, the cost stays in the prepaid expenses asset account. o Some of these operating costs involve purchases on credit that generate accounts payable. o Some of these operating costs are from recording unpaid expenses in the accrued expenses payable liability. Borrowing money on notes payable causes interest expense. A portion (usually relatively small) of income tax expense for the year is unpaid at yearend, which is recorded in the accrued expenses payable liability. Earning net income increases retained earnings.

Financial records and documents

Accounting involves the creation of financial records of business transactions, flows of finance, the process of creating wealth in an organisation, and the financial position of a business at a particular moment in time. A number of users make use of accounts for different purposes: Shareholders read accounts to examine the health of business, and the returns (dividends) that they can expect to make. Employees read accounts to see how safe their jobs are. The Inland Revenue read accounts to calculate how much tax businesses should be paying. Suppliers read accounts to check that the company they supply with goods on credit will be able to pay the money owed when it becomes due. In a typical large business the accounting function might be organised in the following way: Financial accounting is concerned at one level with book-keeping i.e. recording daily financial activities, and at a more advanced level with preparation of the final accounts e.g. the profit and loss account and balance sheet. Management accounting is concerned with providing managers with management information such as information about costs, and forecasts of future costs and revenues. Financial information can be fed to those who require such information for decision-making and record-keeping purposes. For example, managers need information in order to manage the business efficiently and constantly to improve their decision-making capabilities. Shareholders need to assess the performance of managers and need to know how much profit of income they can take from the business. Suppliers need to know about the company's ability to pay its debts and customers wish to ensure that their supplies are secure.
Financial performance

Any provider of finance of the business (e.g. bank) will need to know about the company's ability to make repayments. The Inland Revenue needs information about profitability in order to make an accurate tax assessment. Employees have a right to know how well a company is performing and how secure their futures are. The reasons why businesses keep accounts for these users can therefore be summarised as: 1.To comply with legal and other requirements e.g. Stock Exchange listing rules. 2.To provide information for stakeholders about financial performance and viability. 3.To provide managers with information for decision making. 4.To provide a structure to business activity based on the careful processing of numerical data. Public limited companies like BT, Cadbury-Schweppes and Polestar produce an annual report including a set of financial statements. These statements are produced in line with a number of UK and international accounting standards, and provide users with a clear picture of business performance over the previous year (through the Profit and Loss Account) as well as a clear picture of the financial position of the business at the end of the financial year (in the Balance Sheet). Financial statements must provide a 'true and fair' description of the financial position of a company in line with accounting standards.