Transaction Analysis

 

Question: Transaction 1—A company buys inventory on credit for $2,000. How does transaction analysis work here? What accounts are affected by this purchase?

 

Answer: Inventory, which is an asset, increases by $2,000. The organization has more inventory than it did prior to the purchase. Because no money has yet been paid for these goods, a liability for the same amount has been created. The term accounts payableShort-term liabilities to pay for goods and services that have been acquired. is often used in financial accounting to represent debts resulting from the acquisition of inventory and supplies.

inventory (asset) increases by $2,000 accounts payable (liability) increases by $2,000

Note that the accounting equation described in the previous chapter remains in balance. Assets have gone up by $2,000 while the liability side of the equation has also increased by the same amount to reflect the source of this increase in the company’s assets.

Question: Transaction 2—A company pays a salary of $300 to one of its employees for work performed during the past week. No amount had previously been recorded by the accounting system for this amount. What accounts are affected by this salary payment?

 

Answer: Cash (an asset) is decreased here by $300. Whenever cash is involved in a transaction, determining that change is a good place to start the analysis. Increases and decreases in cash are often obvious.

The cash balance declined here because salary was paid to an employee. Assets were reduced as a result of the payment. That is a cost to the company. Thus, a salary expense of $300 is reported. Recognizing an expense is appropriate rather than an asset because the employee’s work reflects a past benefit. The effort has already been carried out, generating revenues for the company in the previous week rather than in the future.

salary expense (expense) increases by $300 cash (asset) decreased by $300

The continued equilibrium of the accounting equation does exist here although it is less obvious. Assets are decreased. At the same time, an expense is recognized. This expense reduces reported net income. On the statement of retained earnings, current net income becomes a component of retained earnings. The reduction in income here serves to decrease retained earnings. Because both assets and retained earnings go down by the same amount, the accounting equation continues to balance.

 

Question: In Transaction 2, the company paid a salary of $300 that it owed to a worker. Why does a payment to an employee not reduce a salary payable balance?

 

Answer: Costs such as salary, rent, or interest increase gradually over time and are often referred to as accrued expenses because the term “accrue” means “to grow.” An accounting system can be mechanically structured to record such costs in either of two ways. The results are the same but the steps in the process differ.

• Some companies simply ignore accrued expenses until paid. At that time, the expense is recognized and cash is reduced. No liability is entered into the accounting system or removed. Because the information provided above indicates that nothing has been recorded to date, this approach is used here.
• Other companies choose to program their computer systems so that both the expense and the related liability are recognized automatically as the amount grows. For salary, as an example, this increase could literally be recorded each day or week based on the amount earned by employees. At the time payment is finally conveyed, the expense has already been recorded. Thus, the liability is removed because that debt is being settled. Below, in Transaction 5, this second possible approach to recording accrued expenses is illustrated.

A company can recognize an accrued expense (such as a salary) as incurred or wait until payment. This decision depends on the preference of company officials. The end result (an expense is reported and cash decreased) is the same, but the recording procedures differ. As will be discussed, if no entry has been made for such costs prior to the production of financial statements (the first alternative), both the expense and the payable do have to be recognized at that time so that all balances are properly stated for reporting purposes.

Question: Transaction 3—A company borrows $9,000 from a bank. What is the impact of signing a loan agreement with a bank or other lending institution?

 

Answer: Cash is increased by the amount of money received from the lender. The company is obligated to repay this balance and, thus, has incurred a new liability. As with many transactions, the financial impact is reasonably easy to ascertain.

cash (asset) increases by $9,000 note payable (liability) increases by $9,000