In this section I demonstrate examples from the text in the first step of the accounting cycle
Note the effect of these transactions on the accounting equation (balance sheet), the profit and loss statement and statement of cash flow
Event 1: Cato Consultants was started on January 1, 2013, when it acquired $5,000 cash by issuing common stock.
When cash is exchanged for common stock (equity), cash (asset) and common stock (equity) increases
Effect on accounting equation (balance sheet)
Assets
Liab.
Equity
Cash
+
Supplies
=
+
Common Stock
+
Retained Earnings
5,000
+
n/a
=
n/a
+
5,000
+
n/a
Effect on profit and loss statement
Revenue
–
Expenses
=
Net Income
n/a
–
n/a
=
n/a
Effect on cash flow statement
5000
FA
There is an increase in cash from issuing common stock ( financing the business with equity)
Event 2: During 2013, Cato Consultants provided $84,000 of consulting services to its clients but no cash has been collected
Accrual accounting requires companies to recognize revenue in the period in which the work is done regardless of when cash is collected. So therefore, revenue must be recognized in the current accounting period.
When revenue increases, an asset must also increase. Since cash was not collected, the corresponding account is called accounts receivable (an asset account). This is an account that keeps track of how much customers owe the business.
Effect on accounting equation (balance sheet)
Assets
Liab.
Equity
Cash
+
Accounts Rec.
=
+
Common Stock
+
Retained Earnings
n/a
+
84,000
=
n/a
+
n/a
+
84,000
Effect on profit and loss statement
Revenue
–
Expenses
=
Net Income
84,000
–
n/a
=
84,000
Effect on cash flow statement
n/a
Cash received from revenue is cash flow from operating activities
However, no cash was received from this transaction (Accounts Rec.)
Event 3: Cato collected $60,000 cash from customers in partial settlement of its accounts receivable.
Notice the collection of cash did not affect the income statement.
The revenue was recognized when the work was done.
However, since cash is involved there is an increase in cash in the operating activities section of the statement of cash flow.
Increase assets (cash).
Decrease assets (accounts receivable)
This is an Asset Exchange Transaction
Effect on accounting equation (balance sheet)
Assets
Liab.
Equity
Cash
+
Accounts Rec.
=
+
Common Stock
+
Retained Earnings
60,000
+
-60,000
=
n/a
+
n/a
+
n/a
Effect on profit and loss statement
Revenue
–
Expenses
=
Net Income
n/a
–
n/a
=
n/a
Effect on cash flow statement
60,000
OA
Cash received from revenue is cash flow from operating activities
Event 4: Cato paid the instructor $10,000 cash for teaching training courses (salary expense).
Decrease cash (assets).
Decrease retained earnings (equity) – The increase in expense reduces retained earnings.
This is an Asset Use Transaction
Effect on accounting equation (balance sheet)
Assets
Liab.
Equity
Cash
+
Accounts Rec.
=
+
Common Stock
+
Retained Earnings
-10,000
+
n/a
=
n/a
+
n/a
+
-10,000
Effect on profit and loss statement
Revenue
–
Expenses
=
Net Income
n/a
–
-10,000
=
-10,000
Effect on cash flow statement
-10,000
OA
Cash paid for operating expenses
Event 5: Cato paid $2,000 for advertising costs. The advertisements appeared in 2013.
Advertising costs is a period costs (expensed when incurred)
Decrease retained earnings (equity) – The increase in expense reduces retained earnings.
This is an Asset Use Transaction
Effect on accounting equation (balance sheet)
Assets
Liab.
Equity
Cash
+
Accounts Rec.
=
+
Common Stock
+
Retained Earnings
-2,000
+
n/a
=
n/a
+
n/a
+
-2,000
Effect on profit and loss statement
Revenue
–
Expenses
=
Net Income
n/a
–
-2,000
=
-2,000
Effect on cash flow statement
-2,000
OA
Cash paid for operating expenses
Event 6: Cato signed contracts for $42,000 of consulting services to be performed in 2014.
Not recognized in the 2013 financial statements
Next we move on to step 2 of the accounting cycle and we see how to make adjusting entries before closing the books at the end of the accounting period.
Chapter 2 Page 64-84
