Transaction - C- Purchase of Supplies On credit

Mr. X purchased $850 of gasoline, oil, and other supplies and agreed to pay the money in the near
future. This type of transaction is called purchase on account and liability (account payable) is created.
The transaction’s effect is increasing both the assets and liability amounts.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Account Payable Mr. X Capital Bal. 2,500 7,500
10,000
(A) 850 850 Bal. 2,500 850
7,500 850 10,000

Goods that are physical consumed, such as a chalk to a school, gas oil for car, and stationry materials for
an office, are called supplies.

Transaction –D- Payment of liability

Mr. X paid for creditor $400 for the supplies purchases in the above transaction, the effect is decreasing the
assets and liabilities.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Account Payable Mr. X Capital Bal. 2,500 850 7,500
850 10,000
(B) - 400 - 400
Bal. 2,100 850 7,500 450 10,000

Transaction -E- providing or Selling of service

Mr. X taxi provided taxi services for the customers and earned fares (revenue) of $ 4,500, Mr. X
received the total amount of cash from the customers. In general, the amount charged to customers for
goods or services sold is called revenue. Instead of requiring the payment of cash at the time goods or
services are sold, a business may make sales on account, allowing the customers to pay latter. In such
cases, the firm acquires an account receivable, which is a claim against the customers. Accounts
receivable is as much as an asset as cash and revenue is realized. The effect of this transaction is
increasing both the assets and owner’s equity.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Account Payable Mr. X Capital Bal. 2,100 850
7,500 450 10,000
(E) +4,500 4,500 Fares earned
Bal. 6,600 850 7,500 450 14,500
Transaction -F- Payment and Recording Expenses
The amount of assets consumed or services used in the process of earning or generating revenue is called
expenses. Mr. X taxi incurred and paid the following expenses during the month: wages
$1,125; rent $850; utilities $ 150; miscellaneous $ 75. The effect of this transaction is reducing both
assets and owner’s equity.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Account Payable Mr. X Capital Bal. 6,600 850
7,500 450 14,500
(F) -2,200 - 1,125 Wage expense
-850 Rent expense
- 150 Utilities expense
-75 Miscellaneous expense
Bal. 4,400 850 7500 450 12,300

Transaction -G- Recording Expenses

Mr. X’s supplies on hand (not yet used) accounts for $ 250 at the end of the month, the reminder 600
(850 - 250) have been used in the operation of the business. The effect of this internal transaction is
decreasing both assets and owner’s equity.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Account Payable Mr. X Capital Bal. 4,400 850
7500 450 12,300
(G) - 600 -600 Supplies Expense Bal. 4,400 250
7,500 450 11,700

Transaction -H- Owner’s Withdrawal

At the end of the month, Mr. X withdraws $1,000 in cash from the business for his personal use. This
internal transaction reduces the assets and owner’s equity.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Account Payable Mr. X Capital
Bal. 4,400 250 7,500 450 11,700
-1,000 -1,000 Withdrawal
Bal. 3,400 250 7,500 450 10,700
The transactions of ABC Taxi Service can be summarized in a tabular form as shown below. Letters
identifies the transactions here and the balance of each item is shown after each transaction.

Summary of the above “A” to “H” transactions presented as follow:

Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Account payable + Mr. X Capital
(A) 10,000 7,500 10,000 Investment
(B) -7,500
2,500 7,500 10,000
(C) 850 850
2,500 850 7,500 850 10,000
(D) -400 - 400
2,100 850 7,500 450 10,000
(E) 4,500 +4,500 Fares earned
6,600 850 7,500 450 14,500
(F) -2,200 -1,125 Wages expense
-850 Rent expense
-150 Utility expense
-75 Misc. expense
4,400 850 7,500 450 12,300
(G) -600 -600 Supplies expense
4,400 250 7,500 450 11,700
(H) -1,000 -1,000 Withdrawal
3,400 250 7,500 450 10,700

As the above summary shows, at the end of transaction “H”, ABC Taxi Company has a total cash of
$3,400, supplies of $250, land of $7,500, and the company also owed (liability) $450 to others and the
owner equity is $10,700. The following points apply for all types of business:

1. The effect of every transaction increases and/or decreases one or more of accounting
equations elements.
2. Equality of the two sides of the accounting equation should be satisfied always.
3. Owner’s equity is increased by the amounts invested by the owner and revenues
earned. In contrast, it’s decreased by the amounts withdrawal made by the owner and
expenses incurred.
 Owner’s Equity

+ -
Decreased Increased

 Owners  Owners
withdrawals Investment

 Expenses  Revenues

1.1. Financial Statements

After the effect of the individual transaction has been determined, essential information is
communicated to users. The accounting statements or reports that communicate this information are
called financial statements. Generally, there are four types of financial statements.

1.1.1. Financial Statements for Sole Proprietorship and Partnerships

The principal financial statements for sole proprietorship are the following:
1. Income Statement: It is a summary of revenues and expenses of a business entity for
specific period of time, such as a month or a year. The excess of revenues over expenses is
called net income or net profit. If the expenses exceed the revenues, the excess is net loss.
The determination of the periodic net income or net loss is a matching process involving
two steps. First, revenues are recognized during the period. Second, the assets consumed in
generating these revenues must be matched against the revenues in order to determine the
net income or net loss.

2. Statement of Owner’s Equity: It is a summary of the changes in the owner’s equity of a

business entity that have occurred during specific period of time. Increases in owner’s
equity come from: owner investments and net income, and decreases in owner’s equity result from:
owner’s withdrawals and net loss.

3. Balance Sheet: It is a list of assets, liabilities and owner’s equity of a business entity as of
a specific date. The assets section of a balance sheet (left hand side) begins with cash
followed by receivables, supplies, prepaid insurance and other assets that can be converted
in to cash or used up in the near future. The assets of relatively permanent nature such as
land, building and equipment follow that order. In the liability and owner’s equity section of
the balance sheet (right hand side), the liabilities presented first followed by owner’s equity.
4. Statement of Cash Flows: It reports the cash coming in (cash receipts) and the amount of
cash going out (cash payments) during a period. Business activities result in a net cash
inflow (receipts greater than payments) or a net cash outflow (payments greater than
receipts). The statement of cash flows shows the net increase or decrease in cash during the
period and the ending cash balance. This statement is reported in three sections: operating
activities, investing activities, and financing activities.
i. Operating Activities: This section includes cash transactions that enter in to the
determination of net income or net loss. The net cash flow from operating activities
normally differs from the amount of net income for the period.
ii. Investing Activities: This section includes the cash transaction for the acquisition and
sale of relatively long term or permanent type of assets.
iii. Financing Activities: This section includes the cash transaction related to cash
investment by the owner’s and borrowing and withdrawals by the owner.

NB: the cash balance at the beginning of the period is added to the increase (or decrease) in cash
for the period to obtain the cash balance at the end of the period.

Activity

Question 4: What are the four types of financial statements?

The basic features of the four statements and their interrelationships are illustrated by taking data from
Mr. X taxi business as follow:
ABC Taxi Company Income Statement
For Month Ended January 31, 2016
Fares Earned $4,500
Operating Expenses :
Wages Expenses $1,125
Rent Expenses 850
Supplies Expenses 600
Utilities Expenses 150
Miscellaneous Expenses 75
Total Expenses 2,800
Net Income $1,700

ABC Taxi Company Statement of Owner’s Equity

For Month Ended January 31, 2016
Investment During the Month $10,000
Net Income for the Month $1,700
Less: Withdrawal 1,000
Increase in Owner’s Equity 700
Mr. X Capital, January 31, 2016 $10,700

ABC Taxi Company Balance Sheet January 31, 2016

Assets
Cash $3,400
Supplies 250
Land 7,500
Total Assets $11,150
Liabilities
Account Payable $450
Owner’s Equity
Mr. X Capital $10,700
Total Liabilities and Owner’s Equity $11,150
 ABC Taxi Company Statement of Cash Flow
For Month Ended January 31, 2016
Cash Flows from Operating Activities:
Cash Received from Customers $4,500
Deduct: Cash Payments for Expenses And Payment to Creditor 2,600
Net Cash Flow from Operating Activities $1,900
Cash Flows from Investing Activities:
Cash Payments for Acquisition of Land (7,500)
Cash Flows from Financing Activities:
Cash Received as Owner’s Investment $10,000
Deduct: Cash Withdrawal by Owner 1,000
Net Cash Flow from Financing Activities 9,000
Net Cash Flow And January 31, 2016 Cash Balance $3,400

In general, the information generated by the income statement, is entered in to the statement of owner’s
equity. And the information generated by the statement of owner’s equity is entered in the balance sheet
in the list of owner’s equity. Moreover, the information generated by the statement of cash flow is
entered in the balance sheet in the list of Assets.
1.1.2. Financial Statement for Corporation
Business enterprises with large amount of assets are usually organized as corporations and have many
owners, called stockholders. The financial statements of corporations are similar to those of sole
proprietorship and partnership except that retained earnings statement is prepared instead of statement of
owner’s equity. The owner’s equity section of balance sheet is referred to as stockholders' equity rather
than owner’s equity. In addition, the cash flows from financing activities for a corporation arise from the
sale of capital stock and the payment of dividends, rather than from owner’s investment and drawings.

1. Statement of Retained Earning: The emphasis in reporting the changes in the stockholders’
equity is on the changes in retained earnings, or net income retained in the business. The
changes in retained earning that have occurred during a period are reported in retained
earnings statement. Change in the amount of earnings retained in the business would have
resulted from (1) net income and (2) distribution of earnings, called dividends, to owners.
2. Balance Sheet: The only difference between the balance sheet of sole proprietorship or/and
partnership and corporation is that the stockholders’ equity section is presented rather than
owner’s equity.
3. Statement of Cash Flows: The only difference between cash flows statement of corporation
and sole proprietorship or/and partnership is on the cash flows from financing activities
section, i.e., cash flows arise from the sale of capital stock and the cash payments to
stockholders in the form of dividends.
4. Income Statement: Similar with the income statement prepared for sole proprietorship
or/and partnership. Illustrations of financial statements for the corporation type of business
assuming ABC Taxi Company was established as corporation:

ABC Taxi Company

Retained Earnings Statement
For the Month Ended January 31, 2016
Net Income for the Month $1,700
Less: Dividends 1,000
Retained Earnings, January 31, 2016 $700

ABC Taxi Company

Balance Sheet
January 31, 2016
Assets
Cash $3,400
Supplies 250
Land 7,500
Total Assets $11,150
Liabilities
Account Payable $450
Stockholders’ Equity
Capital Stock $10,000
Retained Earnings 700
Total Stockholders’ Equity 10,700
Total Liabilities and Stockholders’ Equity $11,150
 ABC Taxi Company
Statement of Cash Flow
For Month Ended January 31, 2016
Cash Flows from Operating Activities:
Cash Received from Customers $4,500
Less: Cash Payments for Expenses And Payment to Creditor 2,600
Net Cash Flows from Operating Activities $1,900
Cash Flows from Investing Activities:
Cash Payments for Acquisition of Land (7,500)
Cash Flows from Financing Activities:
Cash Received from Sale of Capital Stock $10,000
Less: Cash Payment for Dividends 1,000
Net Cash Flow from Financing Activities 9,000
Net Cash Flow and January 31, 2016 Cash Balance $3,400

1.2. Summary
Explain the meaning of accounting. Accounting is the process of identifying, measuring recording and
communicating the economic events of an organization (business or non business) to interested users of
the information. Accounting helps us in the allocation of scarce resources in an efficient and effective
manner.

Identify the users and uses of accounting. (a) Management uses accounting information in planning
controlling and evaluating business operations. (b) Investors (owners) judge the wisdom of buying,
holding, or selling their financial interests on the basis of accounting data, i.e. to see how their
investment is doing. (c) Creditors evaluate the risks of granting credit or lending money. Other groups
of users include taxing authorities, regulatory agencies, customers, labor unions, and economic panniers.
These users are grouped in to two: 1- Internal users and ii-External users.

Explain the meaning of generally accepted accounting principles: Generally accepted accounting
principles are a common set of standards used by accountants.

Explain the meaning of business entity assumption, cost principle and the monetary unit assumption.
The business entity concept states the economic events of a particular business should be identified
separate from other entities and the owner’s personal records. The cost principle requires properties
acquired by business enterprises to be recorded at actual amounts
paid and /or assumed in acquiring the properties. The monetary unit assumption requires
only transactions capable of being expressed in terms of money be included in the
accounting records of the business enterprise.

State the basic accounting equation and explain the meaning of assets, liabilities, and
owner’s equity. The basic accounting equation is:

Assets = Liabilities + Owner’s Equity.

Assets are resources owned by a business, liabilities represent the claim of creditors on
the total assets, and owner’s equity is the ownership claim on the total assets. It is often
referred to as residual equity.

Analyze the effects of business transactions on the basic accounting equation. Each
business transaction must have a dual effect on the accounting equation. For example, if
an asset is decreased, there must be a corresponding (1) Increase in another asset, or (2)
decrease in a specific liability, or (3) decrease in owner’s equity. After each transaction,
the equality of assets to the sum of liabilities and Owner’s equity must be maintained.

Prepare an income statement, owner’s equity statement, and balance sheet. An income
statement presents the revenues and expenses of a company for a specific period of time.
An owner’s equity statement summarizes the changes in owner’s equity that have
occurred for a specific period of time. A balance sheet reports the assets, liabilities, and
owner’s equity of a business at a specific date.