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How Are Business Transactions and

Financial Statements Related to the

Accounting Equation?

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

1. Accounting Equationo

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

Account Classification

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

Transaction Recording

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


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cash and an increase in bank loan payable. Bank loan payable represents aliability.

Financial Statements

After an accountant records all the transactions for a month, he prepares to createfinancial statements. Each dollar amount recorded rests in a particular account. Thefinancial statements build on the accounting equation using the account classificationassigned. The income statement includes all accounts classified as revenues andexpenses. This statement calculates the net income for the period. The balance sheetincludes all assets, liabilities and equity accounts and follows the format of theaccounting equation. The retained earnings account that appears on a balance sheetincludes the net income reported on the income statement.


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Relationship between Financial Statements

Explanation

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


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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 outsidethe 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 thestatement of changes in equity;

The decrease in net assets and equity arising from the payment of dividends as presented in thestatement of changes in equity;

The change in composition of balances arising from inter balance sheet transactions notincluded 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 theincome 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 underthe segment of cash flows from operation after adjustment of non-cash transactions. Net profit orloss during the year is also presented in the statement of changes in equity.

Statement of Changes in Equity

Statement of Changes in Equityis directly related to balance sheet and income statement.

Statement of changes in equity shows the movement in equity reserves as reported in the entity'sbalance sheet at the start of the period and the end of the period. The statement therefore includesthe change in equity reserves arising from share capital issues and redemptions, the payments ofdividends, net profit or loss reported in the income statement along with any gains or lossesrecognized directly in equity (e.g. revaluation surplus).
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Cash Flow Statement

Statement of Cash Flowsis primarily linked to balance sheet as it explains the effects of changein cash and cash equivalents balance at the beginning and end of the reporting period in terms ofthe 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 disposalsof assets (i.e. investing activities)
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Basic Financial Statements

The accounting process


The Accounting EquationChart 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 financialrecords. A number of federal and state laws require this. But even if therewere no laws, it would still be a good idea anyway. Businesses providevital goods and services to those living in the community. They providejobs for people, and tax dollars that improve our roads, parks and schools.It is in everyone's best interest that our community's businesses besuccessful.

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 peopleto work in the business.... all this done with the hope that the business will be successful. And ifthe business is NOT a success, the owner may have lost his or her life's savings, workers mustfind jobs, and creditors may go unpaid.

Financial information may not make a business successful, but it helps the owner make soundbusiness decisions. It can also help a bank or creditor evaluate the company for a loan or chargeaccount. And the IRS will be interested in collecting the appropriate amount of income tax. Sofinancial 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 formatthat 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 beequally useless. Financial statements summarize a large number of Transactionsinto a small number of significant categories. To be useful, information must be

organized.
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Financial statements have generally agreed-upon formats and follow the same rules ofdisclosure. This puts everyone on the same level playing field, and makes it possible to comparedifferent companies with each other, or to evaluate different year's performance within the samecompany. There are three main financial statements:

1.

Income Statement2. Balance Sheet3. 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) Liabilities3) Owners' Equity (Stockholders' Equity for a corporation)4) Revenues5) Expenses

All the accounts in an accounting system are listed in a Chart of Accounts. They are listed inthe order shown above. This helps us prepare financial statements, by conveniently organizingaccounts in the same order they will be used in the 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 withGAAP. Financial statements presented separately do not comply with GAAP. This is necessaryso financial statement users get a true and complete financial picture of the company.


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All accounts are used in one or the other statement, but not both. All accounts are used once, andonly once, in the financial statements. The Balance Sheet shows account balances at a particulardate. The Income Statement shows the accumulation in the Revenue and Expense accounts, for agiven period of time, generally one year. The Income Statement can be prepared for any span oftime, and companies often prepare them monthly or quarterly.

It is common for companies to prepare a Statement of Retained Earnings or a Statement ofOwners' Equity, but one of these statement is not required by GAAP. These statements provide alink 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 fulldisclosure. The Cash Flow statement shows the inflows and outflows of Cash over a period oftime, usually one year. The time period will coincide with the Income Statement. In fact, accountbalances are not used in the Cash Flow statement. The accounts are analyzed to determine theSources (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 operations2) 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 theirfinancial statements. That doesn't mean companies do what they are supposed to do. Enronexecutives had millions of reasons ($$) to falsify financial information for their own personalgain. Auditors are independent CPAs hired by companies to determine whether the rules ofGAAP and full disclosure are being followed in their financial statements. In the case of Enronand Arthur Andersen, auditors sometimes fail to find problems that exist, and in some casesmight have also failed in their responsibilities as accounting professionals.


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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 recordchanges 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 thebalance sheet (called the debit side) shows the resources of the company (assets), whereas on theright side (or, credit side), it shows how these resources have been funded. By definition, thefunding 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 delivergoods.Equity: funding by the owners, or 'residual claim' (to the assets), which always equals total assetsminus total liabilities.

Example balance sheet

The assets of the fictitous company ABCD Inc. (which is also used later) on January 31st, 20X0consist 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) beenpaid out as dividend.

For corporations the amount raised by issuing shares is presented separately from the profitsretained in the company. For sole proprietorships - a business owned and ran by a singleindividual with no separate legal entity for the business - paid-in capital and retained earnings arenot shown separately. Instead, these items are added and labeled 'capital'.


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Liabilities and equity are a means to attract capital for funding of assets. More debt or equitymeans 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 debtand equity, as well as the optimal mix between the two is outside the domain of financialaccounting.

Since the balance sheet shows the assets and the funding of the assets (liabilities and equity) at apoint in time, it is not possible to infer the performance of the firm from the balance sheet. Thisis because performance is measured over a period. The income statement and the cash flowstatement are used for this purpose (discussed later).

The accounting equation

The accounting equation (Assets = Liabilities + Equity) tells us that the balance sheet is balancedby definition, as all assets will be financed either by the owners themselves (equity) or by otherpeople (liabilities).

Since assets are presented on the debit side of the balance sheet and liabilities and equity on thecredit side, the accounting equation implies the fundamental equation in accounting that totaldebits should equal total credits at all times.

It is important to know that the accounting process is governed by accounting principles thatsometimes are very binding and sometimes provide some flexibility. Well known principlesinclude International Financial Reporting Standards (IFRS) and U.S. GAAP (Generally AcceptedAccounting 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 thecase 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 ofassets (and equity) is below the market value of assets (and equity), since book assets are usuallyunderstated. This difference is expressed by the market-to-book ratio (dividing the market valueof equity by the book value of equity).

Further reading:Additional reading on the market-to-book ratio.
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Analyzing Accounting Transactions

Guest Author - Consuelo Herrera, CAMS, CFE

When the accounting process is complete a set of financial statements is issued. Financialstatements are crucial for investment decisions, tax assessments, conflicts resolution, etc.

The accounting process involves five steps:

1) Analyzing2) Classifying3) Recording4) Summarizing5) Interpreting

Although all these steps are very important, analyzing a transaction grants reliance and relevanceto the financial information. To be useful, accounting information must be both reliable andrelevant. Decision-makers seek valuable information in which they can rely on when makinginformed 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, OwnersEquity, 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. Forexample, if a forensic accountant is hired to help solve a dispute between two stockholders of acorporation, he or she will analyze the business transactions of the entity, establishingmeaningful relationships among different accounts. From this initial input the accountant willhave 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 areexpressed in terms of money.

When confronted with a set of business transactions, we look for the impact they have on thestockholders equity. Each share of stock has certain rights and privileges spelled out when theshares are issued. The forensic accountant analyzing information will examine the articles ofincorporation, stocks certificates, and laws and regulations.

The following are the rights that each share carries, unless differently stated in corporatedocuments:


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o To share proportionately in profits and losseso To share proportionately in managemento 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 practicewas deceitful to investors, creditors, and suppliers. The impact of recording those notes was anincrease on the accounting assets when the following entry was made:

Notes Receivable $ xxxxStockholders Equity $xxxx

The Securities and Exchange Commission, SEC, emphasized that it was an accounting errorsince 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 berecorded as a contra-equity account, a deduction from stockholders equity.

Properly analyzing transactions prevents the issuance of misleading financial statements andincrease 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 lessondouble 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.
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The accounting equation refers to the balance sheet, where assets are shown on the debit side andthe funding (liabilities and equity) on the credit side. If the accounting equation holds for thebalance sheet at a point in time, it must hold for the beginning of period balance sheet as well asthe end of period balance sheet. It then logically follows the accounting equation must also holdfor changes; i.e., for each transaction the change in assets must equal the change in liabilities

plus the change in equity: Assets = Liabilities + Equity.


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Connecting the Income Statement and

Balance Sheet

ByJohn A. Tracy, CPAfromAccounting Workbook For Dummies

When an accountant records a sale or expense entry using double-entry accounting, he or shesees the interconnections between the income statement and balance sheet. A sale increases anasset 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 otherside is in the balance sheet. You cant record a sale or an expense without affecting the balancesheet. 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 pagein the annual financial report, and the threads of connection between the financial statementsarent referred to.

The following figure shows the lines of connection between income statement accounts andbalance sheet accounts. When reading financial statements, in your minds eye, you should seethese lines of connection. Because financial reports dont offer a clue about these connections, itmay help to actually draw the lines of connection, like you would if you were highlighting linesin a textbook.
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Connections between income statement and balance sheet accounts.

Heres a quick summary explaining the lines of connection in the figure, starting from the topand working down to the bottom:

Making sales (and incurring expenses for making sales) requires a business to maintain aworking cash balance.

Making sales on credit generatesaccountsreceivable. 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 year-

end, which is recorded in the accrued expenses payable liability. Earning net income increases retained earnings.
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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 aparticular 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) thatthey can expect to make. Employees read accounts to see how safe their jobs are. The InlandRevenue read accounts to calculate how much tax businesses should be paying. Suppliers readaccounts to check that the company they supply with goods on credit will be able to pay themoney owed when it becomes due. In a typical large business the accounting function might beorganised in the following way:Financial accounting is concerned at one level with book-keeping i.e. recording daily financialactivities, and at a more advanced level with preparation of the final accounts e.g. the profit andloss account and balance sheet.Management accounting is concerned with providing managers with management informationsuch 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 andrecord-keeping purposes. For example, managers need information in order to manage thebusiness efficiently and constantly to improve their decision-making capabilities. Shareholdersneed to assess the performance of managers and need to know how much profit of income theycan take from the business. Suppliers need to know about the company's ability to pay its debtsand 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'sability 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 isperforming 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 reportincluding a set of financial statements. These statements are produced in line with a number ofUK 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 clearpicture of the financial position of the business at the end of the financial year (in the BalanceSheet).Financial statements must provide a 'true and fair' description of the financial position of acompany in line with accounting standards.

Documents

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