Recording Transactions using. Financial Statement Approach

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1 Recording Transactions using Financial Statement Approach Service Company Example The current presentation will cover the basics of recording transactions using the financial statement approach. The purpose of this approach is to concentrate on how transactions impact the financial statements specifically the income statement and balance sheet. Although we could include the cash flow statement as well, we will ignore it here to keep things simple. The approach displays the financial statements horizontally in order to conserve space. In addition, we will not keep a running total of the transactions. In fact, we could very well simply record each transaction on a normal income statement and balance sheet. The only real problem with doing so is that things get a bit messy. You should, however, keep in mind how each transaction would simply change the financial statements. This presentation uses Mike s Barbershop as a running example. The important point here is that we have a service company. This type of company often incurs fairly simple transactions though not always. The next presentation will cover a retail business with just slightly more complicated transactions. Manufacturing companies have a few special issues involved that we ll talk about later. The lay-out of the presentation is one page for the transaction and the following page showing how the transaction would be recorded (or, impacts the financial statements).

2 1. Mike transfers $500 from the shop s savings account to its checking account.

3 1. Mike transfers $500 from the shop s savings account to its checking account Cash Savings Mike has merely switched one asset (savings account) for another asset (cash). Note, for our purposes a checking account is part of cash.

4 2. Mike purchases $100 worth of equipment (e.g., scissors, clippers, etc.) for the shop by writing a check.

5 2. Mike purchases $100 worth of equipment (e.g., scissors, clippers, etc.) for the shop by writing a check Equipment -100 Cash Again, we have merely transformed one asset (cash) into another asset (equipment). It will only be when the equipment wears out that we ll recognize an expense. Until the equipment wears out, the scissors, clippers, etc. are assets for the shop.

6 3. Mike purchases a blow dryer for the shop. The dryer costs $50. Mike has asked the seller to bill him for the dryer.

7 3. Mike purchases a blow dryer for the shop. The dryer costs $50. Mike has asked the seller to bill him for the dryer. +50 Equipment + 50 Accounts Payable Mike incurred a liability when he asked the seller to bill him for the purchase of the dryer. It is being assumed here that Mike will pay the bill relatively soon (e.g., within one year) most likely within 30 days. Thus, the liability is a current liability. A typical account name for such liabilities is accounts payable.

8 4. Mike receives the bill for the purchase of the dryer and immediately pays it by putting a check in the mail for the full amount.

9 4. Mike receives the bill for the purchase of the dryer and immediately pays it by putting a check in the mail for the full amount. -50 Cash -50 Accounts Payable

10 5. Mike provides a $15 haircut to a customer that pays cash.

11 5. Mike provides a $15 haircut to a customer that pays cash. +15 Cash +15 Retained Earnings We have our first use of the relationship between the income statement and balance sheet. Recall that the equity portion of the balance sheet contains a running total of profit (or, net income) generated and kept within the business. The account that does this is the retained earnings. Here, we are merely keeping track of the following relationship: Ending Retained Earnings = Beginning Retained Earnings + Net Income Dividends We see that by providing the services Mike has generated revenue that increased net income and thereby increased the retained earnings in the equity portion of the balance sheet. The balance sheet is still in balance because assets (cash) have increased as well. All that this says is that the net income must take a particular form in this case it the form is cash. Finally, we should note that we might like to match the associated expenses with the hair cut but in a service company like a barbershop this may not be possible. When we turn out attention to a retail business we ll see how this works.

12 6. Mike provides a $20 haircut to a customer. The customer a loyal and steady one for Mike has asked Mike to bill him for the haircut.

13 6. Mike provides a $20 haircut to a customer. The customer a loyal and steady one for Mike has asked Mike to bill him for the haircut. +20 Accounts Receivable +20 Retained Earnings Notice how similar this transaction is to the customer that paid cash. Even though Mike has not received the cash for the haircut, we will still recognize that he has in fact earned the revenue. The term accounts receivable signifies an asset for Mike, which will be turned into cash relatively soon (thus, it is a current asset). It simply means that someone owes Mike. What will happen when the customer finally pays for the haircut?

14 7. Mike receives a $20 check from the customer in question 6.

15 7. Mike receives a $20 check from the customer in question Cash -20 Accounts Receivable The payment means that we merely switch one asset (accounts receivable) for another (cash). Notice, we have already recognized and recorded the revenue earned by providing the haircut.

16 8. Mike pays $400 in rent to the owner of his building.

17 8. Mike pays $400 in rent to the owner of his building Cash Retained Earnings Again, we are utilizing the relationship between the balance sheet and income statement. Ending Retained Earnings = Beginning Retained Earnings + Net Income Dividends In this case, the rent represents an expense for Mike that decreases net income and therefore decreases retained earnings and, ultimately decreases the equity (or, net worth). Notice also that the balance sheet still balances because of the decrease in cash.

18 9. Mike receives his $200 utility bill. However, he does not plan to actually pay this until next month (after he constructs this period s financial statements).

19 9. Mike receives his $200 utility bill. However, he does not plan to actually pay this until next month (after he constructs this period s financial statements) Accounts Payable -200 Retained Earnings The only difference between this transaction and the payment of rent is that Mike has decided to wait to pay it. However, if he plans on constructing his financial statement prior to payment, then he will want to recognize the utilities as an expense on the income statement and to show that he does owe (i.e., liability) the amount. Otherwise, the net income on the income statement would be overstated by $200 and the balance sheet would not show the $200 liability.

20 10. Mike receives a $5,000 small business loan from his bank.

21 10. Mike receives a $5,000 small business loan from his bank. +5,000 Cash +5,000 Bank Loan If the bank loan will last longer than one year, then it will be placed in the non-current liability of the balance sheet, probably with the label Long Term Debt.

22 11. Mike makes the first payment of $300 on his bank loan. Of the entire payment, $200 will go towards the principal of the loan and $100 towards interest on the loan.

23 11. Mike makes the first payment of $300 on his bank loan. Of the entire payment, $200 will go towards the principal of the loan and $100 towards interest on the loan Cash Bank Loan -100 Retained Earnings Since $200 went towards the loan outstanding (originally, $5,000) we will want to bring down the liability by that amount. Thus, we decrease the Bank Loan by 200 (the balance now is $4,800). The interest portion of the payment represents an expense for Mike. Thus, this will be put on the income statement and decrease net income. But we know that when we decrease net income, then we are also decrease equity (specifically, the retained earnings account). Is the balance sheet in balance? YES!!!

24 12. The $50 blow dryer that Mike purchased way back in question 3 has worn out completely (it is now worthless with no salvage value at all).

25 12. The $50 blow dryer that Mike purchased way back in question 3 has worn out completely (it is now worthless with no salvage value at all) Equipment -50 Retained Earnings Recall, when we purchased the blow dryer we recorded it as an addition to assets, and not as an expense. At the time, it was something of value for the shop. Now that it has worn out, we recognize the wearing out of the asset as an expense. We will see that for some assets specifically, those long-lived assets we will show them wearing out (i.e., depreciating) slowly over time.

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