Financial Accounting

Impact of External Transactions on the

Accounting Equation

Instructor: Dr. Sheeba Zafar

Analyze the Impact of External
Transactions on the Accounting
Equation

2
 Basic Accounting Equation

Each transaction will have a dual effect.

If an economic event increases one side of the
equation, then it also increases the other side
of the equation by the same amount.

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 Basic Accounting Equation

Assets = Liabilities + Stockholders’ Equity

(RESOURCES) (CLAIMS TO RESOURCES)

4
 Example: External Transactions of
Woods Golf Academy
Type of
Transaction Date External Transactions in January Activity
(1) Jan. 1 Sell shares of common stock for $25,000
to obtain the funds necessary to start the Financing
business.
(2) Jan. 1 Borrow $10,000 from the local bank and
sign a note promising to repay the full Financing
amount of the debt in three years.
(3) Jan. 1 Purchase equipment necessary for giving
Investing
golf training, $24,000.
(4) Jan. 1 Purchase one year of rent in advance for
Operating
$6,000 ($500 per month).
(5) Jan. 6 Purchase supplies on account, $2,300.
Operating
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 External Transactions of Woods Golf
Academy (Cont.,)
Type of
Transaction Date External Transactions in January Activity
(6) Jan. 12 Provide golf training to customers for
Operating
cash, $3,600.
(7) Jan. 17 Provide golf training to customers on
Operating
account, $2,500.
(8) Jan. 23 Receive cash in advance for ten golf
training sessions to be given in the Operating
future, $600.
(9) Jan. 28 Pay salaries to employees, $2,800.
Operating

(10) Jan. 30 Pay cash dividends of $200 to

Financing
shareholders.
6
 Transaction(1): Issue Common Stock
• To begin operations, Woods Golf Academy needs
cash. To generate cash from external sources, Woods
sells shares of common stock for $25,000.
1. “What is one account in the accounting equation
affected by the transaction?
2. Does that account increase or decrease?”
• Answer: Cash. Cash is a resource owned by the
company, which makes it an asset. The company
receives cash from Stock Holders, so cash and total
assets increase by $25,000.

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 Transaction(1): Issue Common Stock
(Cont.,)
Answer:
• Cash. Cash is a resource owned by the company,
which makes it an asset. The company receives cash
from Stock Holders, so cash and Total Assets increase
by $25,000.

To generate cash from external sources, Woods

sells shares of common stock for $25,000.

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 Transaction(1): Issue Common Stock
(Cont.,)
Question:
a) “What is a second account in the accounting
equation affected by the transaction?
b) Does that account increase or decrease?”

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 Transaction(1): Issue Common Stock
(Cont.,)
Answer:
Common stock.
• Common stock is a stockholders’ equity account.
Issuing common stock to Stockholders in exchange of
$25,000 increases the amount of common stock
owned by stockholders.
• Common stock and total stockholders’ equity both
increase.

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Transaction(1): Issue Common Stock
(Cont.,)

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 Transaction(1): Issue Common Stock
(Cont.,)
Question:
• Do assets equal liabilities plus stockholders’
equity?”

• Answer: Yes.

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 Transaction(1): Issue Common Stock
(Cont.,)

Note: The accounting equation balances.

• If one side of the equation increases, so does the
other side.
• We can use this same series of questions to
understand the effect of any business transaction.
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Transaction(2): Borrow from the Bank
• Seeking cash from another external source.
• Woods Academy borrows $10,000 from the bank
and signs a note for it.

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Transaction(2): Borrow from the Bank
(Cont.,)

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Transaction(2): Borrow from the Bank
(Cont.,)
Question:
a) What is one account in the accounting equation
affected by the transaction?
b) Does that account increase or decrease?

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Transaction(2): Borrow from the Bank
(Cont.,)
Answer:
Cash.
• Cash is a resource owned by the company, which
makes it an asset.
• The company receives cash, so cash and total assets
increase.

17
Transaction(2): Borrow from the Bank
(Cont.,)
Question No-2:
a) What is a second account in the accounting
equation affected by the transaction?
b) Does that account increase or decrease?

(2) Jan. 1 Borrow $10,000 from the local

bank and sign a note promising
Financing
to repay the full amount of the
debt in three years.

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Transaction(2): Borrow from the Bank
(Cont.,)
Answer:
Notes payable.
• Notes payable represents the amount owed to a
creditor (the bank in this case), which makes it a
liability.
• The company incurs debt when signing the note, so
Notes Payable and Total Liabilities increase.
Question: Do assets equal liabilities plus stockholders’
equity?
Answer: Yes.
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 Summary of Initial Two Financing
Transactions Woods Gold Academy
• After these two transactions, the accounting
equation remains in balance.
• The total resources of the company equal
$35,000.
• Creditors’ claims to those resources total
$10,000 and the remaining resources of
$25,000 were provided by stockholders.
• Regardless of the number of transactions
occurring during the period, the accounting
equation always must remain in balance.
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 Summary of Initial Two Financing
Transactions Woods Gold Academy

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Transaction(3): Purchase Equipment

(3) Jan. 1 Purchase equipment necessary for

Investing
giving golf training, $24,000.

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 Transaction(3): Purchase Equipment

(3) Jan. 1 Purchase equipment necessary for

Investing
giving golf training, $24,000.

• Once Woods obtains financing by issuing common stock

• Borrowing from the bank, the company can invest in long-
term assets necessary to operate the business.
• Buying equipment from a supplier causes one asset to
increase and another asset to decrease.
Notice: Purchasing one asset (equipment) with another asset (cash)
has no effect on the category totals in the accounting equation. One
asset increases, while another asset decreases.

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Transaction(3): Purchase Equipment
(Cont.,)

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Summary of The Initial Financing and
Investing Transactions of Woods Golf
Academy

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Summary of The Initial Financing & Investing
Transactions of Woods Golf Academy

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Transactions(4) and(5): Incur Costs for
Rent and Supplies

(4) Jan. 1 Purchase one year of rent in advance

Operating
for $6,000 ($500 per month).
(5) Jan. 6 Purchase supplies on account,
Operating
$2,300.

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Transactions(4) and(5): Incur Costs for
Rent and Supplies
(4) Jan. 1 Purchase one year of rent in advance
Operating
for $6,000 ($500 per month).
(5) Jan. 6 Purchase supplies on account,
Operating
$2,300.

• Woods Academy pays one year of rent in advance, $6,000.

• Purchasing rent in advance causes one asset to increase and
one asset to decrease. Because the rent paid is for occupying
space in the future, we don’t want to record it as an expense
immediately.
• We record it as an asset representing the right to occupy the
space in the future.
• We call this asset as prepaid rent.
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Transactions(4) and(5): Incur Costs for Rent
and Supplies

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Transactions(4) and(5): Incur Costs for
Rent and Supplies (Cont.,)

(5) Jan. 6 Purchase supplies on account,

Operating
$2,300.

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Transactions(4) and(5): Incur Costs for
Rent and Supplies (Cont.,)
(5) Jan. 6 Purchase supplies on account, Operating
$2,300.

• Purchases supplies on account, $2,300.

• Purchasing supplies with the promise to pay cash in
the future causes an asset (supplies) to increase and
also creates a liability.
• We refer to a liability of this type, in which we
purchase something on account, as an account
payable.
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Transactions(4) and(5): Incur Costs for
Rent and Supplies (Cont.,)

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 Transactions (6) and (7): Provide
Services to Customers

Type of
Transaction Date External Transactions in January Activity
(6) Jan. 12 Provide golf training to customers for
Operating
cash, $3,600.
(7) Jan. 17 Provide golf training to customers on
Operating
account, $2,500.

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 Transactions (6) and (7): Provide
Services to Customers

Type of
Transaction Date External Transactions in January Activity
(6) Jan. 12 Provide golf training to
Operating
customers for cash, $3,600.

In transaction (6), some customers pay cash at the

time of the training, $3,600. Woods earns revenues

34
 Transactions (6) and (7): Provide
Services to Customers

Type of
Transaction Date External Transactions in January Activity
(7) Jan. 17 Provide golf training to
Operating
customers on account, $2,500.

35
 Transactions (6) and (7): Provide
Services to Customers
Type of
Transaction Date External Transactions in January Activity
(7) Jan. 17 Provide golf training to customers on
Operating
account, $2,500.

• In transaction (7) other customers promise to pay $2,500 cash

at some time in the future.
• The fact that some customers do not pay cash at the time of the
training doesn’t prevent Woods from recording revenue.
• The right to receive cash from a customer is something of value
the company owns, and therefore is an asset.
• When a customer does not immediately pay for services with
cash, we traditionally say the services are performed “on
account” and record an account receivable.
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Transactions(6) and (7): Provide
Services to Customers

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 Transactions(6) and (7):
Provide Services to Customers
Providing service to customers on account causes
both assets and stockholders’ equity to increase

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 Transaction(8): Receive Cash in
Advance from Customer

(8) Jan. 23 Receive cash in advance for ten

golf training sessions to be Operating
given in the future, $600.

39
 Transaction(8): Receive Cash in
Advance from Customer
(8) Jan. 23 Receive cash in advance for ten
golf training sessions to be Operating
given in the future, $600.

• Companies sometimes receive cash in advance from

customers.
• We’re assuming that Woods receives $600 from customers for
golf training to be provided later.
• In this case, the company cannot report revenue from training
now because it has yet to provide the training to earn those
revenues.
• Instead, the advance payment from customers creates an
obligation for the company to perform services in the future, and
this future obligation is a liability (or debt). 40
 Transaction(8): Receive Cash in
Advance from Customer
Receive cash in advance from customers, $600.

Net Retained Stockholders’ Equity

Revenue Income Earnings

41
Transaction(9): Incur Cost for Salaries

(9) Jan. 28 Pay salaries to employees, $2,800.

Operating

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Transaction(9): Incur Cost for Salaries
(9) Jan. 28 Pay salaries to employees, $2,800.
Operating

Companies incur a variety of expenses in generating

revenues. Woods Academy incurs salaries expense of
$2,800.
Paying salaries for the current period causes assets and
stockholders' equity to decrease.
Expenses reduce net income and therefore reduce
retained earnings, a stockholders’ equity account.

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Transaction(9): Incur Cost for Salaries
(Cont.,)
Pay salaries to workers, $2,800

Net Retained Stockholders’ Equity

Expense Income Earnings

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 Transaction (10): Pay Dividend

(10) Jan. 30 Pay cash dividends of $200 to

Financing
shareholders.

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 Transaction (10): Pay Dividend
(10) Jan. 30 Pay cash dividends of $200 to
Financing
shareholders.

The final financing transaction of Woods Golf Academy for the month
is the payment of a $200 cash dividend to stockholders.
Dividends are not expenses. Instead, dividends are distributions of
part of the company’s net income to the owners and thus reduce
retained earnings, a stockholders’ equity account.
Normally a company wouldn’t pay dividends after only a month in
business, but we make this assumption here for purposes of
illustration.
Dividends decrease stockholders’ equity because dividends are
distributions of the company’s earnings (net income) and therefore
reduce retained earnings. Since retained earnings is a stockholders’
equity account, when retained earnings decreases, so does
stockholders’ equity. 46
 Transaction (10): Pay Dividends
Pay dividends to stockholders, $200 reduced claims to
company resources

Retained Stockholders’ Equity

Dividends Earnings

47
Summary of All Ten External
Transactions of Woods Golf
Academy

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