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Lesson 1: Introduction to Accounting and Business

Accounting Transactions and Their Effects on Business

A transaction is a business event that can be measured in terms of money. It is an event that impacts an entity's financial position or affects its operations. Very simply, this could mean paying the light bill, purchasing equipment, or shutting down a factory.

Below, we will analyze and record the transactions for MM TAX for December and later use the results to complete the financial statements.

Remember, assets must equal liabilities plus owner’s equity.

 

 

Recording and Analyzing Transactions: An Example

On December 2, M. McGruber opened a new business, MM TAX. MM TAX is a firm that provides tax services for clients. McGruber decided to incorporate and will be the only stockholder of the corporation.

During December, McGruber had the following transactions:

  • On December 2, McGruber started a new business as a corporation. The business received $20,000 from the stockholder (McGruber), and the company issued common stock to her. Note that the corporation is a separate entity, and we are preparing the financial statements for MM TAX, not McGruber (the individual).
  • On December 3, MM TAX purchased a computer for $500 cash.
  • On December 4, MM TAX purchased office supplies on account for $50.
  • On December 20, MM TAX prepared a tax return for a corporate client and billed the client $2,500.
  • On December 20, MM TAX paid its employee $200 cash for one week’s work.
  • On December 20, MM TAX paid a $200 dividend to its sole stockholder, M. McGruber.
Transaction 1

On December 2, McGruber started a new business as a corporation. The business received $20,000 from the stockholder (McGruber), and the company issued common stock to her.

Note: The corporation is a separate entity, and we are preparing the financial statements for MM TAX, not McGruber (the individual).
Assets = Liabilities + Owner's equity
Cash
-
-
-
Common stock
+$20,000
-
-
-
$20,000

Analysis: The corporation now has $20,000 more cash than it had prior to the transaction. The amount of stock issued by the corporation increased by $20,000; therefore, we increase the common stock account.

We will keep track of the balance in each of our accounts. After this transaction is recorded, we have two accounts with balances: assets and owner's equity.

Assets: Liabilities: Owner's equity:
Cash + $20,000 No liabilities currently exist. Common stock + $20,000

Assets $20,000 = Liabilities $0 + Owner's equity $20,000

Transaction 2

On December 3, MM TAX purchased a computer for $500 cash.

Assets = Liabilities + Owner's Equity
Cash and Computer
-
-
-
-
-$500 and +500
-
-
-
-
Cash
Computer

Analysis: The corporation now has $500 less cash than it had prior to the transaction. The company also has a computer it didn’t have prior to the transaction; therefore, we increase the computer account by $500. The new balance in our cash account is $19,500 (+$20,000 from Transaction 1 and -$500 from Transaction 2).

After this transaction is recorded, we have the following accounts with balances:

Assets: Liabilities: Owner's equity:
Cash $19,500 No liabilities currently exist Common stock +$20,000
Computer + 500
-
-
Total assets $20,000
-
-

Assets $20,000 = Liabilities $0 + Owner's equity $20,000

Transaction 3

On December 4, MM TAX purchased office supplies on account for $50.

Assets = Liabilities + Owner's Equity
Office Supplies
-
Accounts Payable
-
-
+50
-
+50
-
-

Analysis: The corporation now has $50 worth of office supplies that it didn’t have prior to the transaction. The corporation also has $50 in debt. Accounts payable is our promise to pay in the future for services performed for us or for goods purchased. The term "on account" tells us that we purchased these supplies while giving our promise to pay in the future (liability).

After this transaction is recorded, we have the following accounts with balances:

Assets: Liabilities: Owner's equity:
Cash $19,500 Accounts payable $50 Common stock +$20,000
Office supplies $50
-
-
Computer + 500
-
-
Total assets $20,050
Total liabilities: $50
Total owner's equity $20,000

Assets $20,050 = Liabilities $50 + Owner's Equity $20,000

Transaction 4

On December 20, MM TAX prepared a tax return for a corporate client and billed the client $2,500.

Assets = Liabilities + Owner's Equity
Accounts receivable
-
-
-
Feed Earned
+$2,500
-
-
-

+2,500
This will be recorded as a revenue account, not owner's equity in lesson 02

Analysis: The corporation received a promise of future payment from a client (accounts receivable) for services performed (fees earned). The client’s promise to pay within one month (accounts receivable) is a claim (asset) of $2,500. The corporation has performed $2,500 worth of services, which increases our revenue earned account (fees earned) for the period.

After this transaction is recorded, we have the following accounts with balances:

Assets: Liabilities: Owner's equity:
Cash $19,500 Accounts payable $50 Common stock +$20,000
Accounts receivable $2,500 - Fees earned +2,500
Office supplies $50
-
-
Computer + 500
-
-
Total assets $22,550 Total liabilities: $50 Total owner's equity $22,500

Assets $22,550 = Liabilities $50 + Owner's equity $22,500

Transaction 5

On December 20, MM TAX paid its employee $200 cash for one week’s work.

Assets = Liabilities + Owner's Equity
Cash
-
-
-
Salary expense
-$200
-
-
-

-$200
These will be recorded as an addition to an expense account in lesson 02. In lesson 01 expenses are recorded as a reduction in owner's equity. 

Analysis: The corporation now has $200 less cash than it had prior to the transaction. The balance in our cash account has been reduced by $200, from $19,500 to $19,300. Salary expense is a normal cost incurred in the selling of goods or services.

After this transaction is recorded, we have the following accounts with balances:

Assets: Liabilities: Owner's equity:
Cash $19,300 Accounts payable $50 Common stock +$20,000
Accounts receivable $2,500
-
Fees earned +2,500
Office supplies $50
-
Salary expense -$200
Computer + 500
-
-
Total assets $22,350 Total liabilities: $50 Total owner's equity $22,300

Assets $22,350 = Liabilities $50 + Owner's equity $22,300

Transaction 6

On December 20, MM TAX paid a $200 dividend to its only stockholder, M. McGruber.

Assets = Liabilities + Owner's Equity
Cash
-
-
-
Dividends paid
-$200
-
-
-

-$200

Analysis: The corporation now has $200 less cash than it had prior to the transaction. The balance in our cash account has been reduced by $200, from $19,300 to $19,100. Dividends are distributions of cash or other assets to the stockholders. Note that dividends do not appear on the balance sheet. They are closed to retained earnings before the balance sheet is prepared (explained in Lesson 4).

Note: Dividends are not expenses; they are the distribution of assets to owners. This is one of the mistakes that students commonly make.

After this transaction is recorded, we have the following accounts with balances:

Assets: Liabilities: Owner's equity:
Cash $19,100 Accounts payable $50 Common stock +$20,000
Accounts receivable $2,500
-
Dividends -200
Office supplies $50
-
Fees earned +2,500
Computer + 500
-
Salary expense -$200
Total assets $22,150 Total liabilities: $50 Total owner's equity $22,100

Assets $22,150 = Liabilities $50 + Owner's equity $22,100

The balances in the accounts for MM TAX will be used to prepare financial statements.


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