Subject 4. Effects of Transactions on the Accounting Equation

The following illustrates how the business transactions of ABC Realty are recorded in a simplified accounting system.

1. Owners' Investments - Invested $50,000 in business in exchange for 5,000 shares of $10 par value stock.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
A = $50,000
L + OE = $50,000
Notice A = L + SE is always in balance.

2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for $25,000.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
bal $15,000

$10,000 $25,000

$50,000
A = $50,000
L + OE = $50,000
This transaction only affects one side of the accounting equation: assets.
Whenever a transaction affects only one side of the accounting equation, both assets and liabilities and owners' equity remain unchanged.

3. Purchase of Assets by Incurring a Liability - Purchased office supplies for $500 on credit.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

bal $15,000
$500 $10,000 $25,000
$500 $50,000
A = $50,500
L + OE = $50,500

4. Payment of a Liability - Paid $200 of the $500 owed for supplies.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

4 -200




-200

bal $14,800
$500 $10,000 $25,000
$300 $50,000
A = $50,300
L + OE = $50,300

5. Revenues - Earned and received a commission of $1,500 in cash.
Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

4 -200




-200

5 1,500






$1,500
bal $16,300
$500 $10,000 $25,000
$300 $50,000 $1,500
A = $51,800
L + OE = $51,800

6. Earned a commission of $2,000 to be received at a later date.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

4 -200




-200

5 1,500






$1,500
6
$2,000





2,000
bal $16,300 $2,000 $500 $10,000 $25,000
$300 $50,000 $3,500
A = $53,800
L + OE = $53,800

7. Collection of Accounts Receivable - Received $1,000 from client for commission earned earlier in the month.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

4 -200




-200

5 1,500






$1,500
6
$2,000





2,000
7 1,000 -1,000






bal $17,300 $1,000 $500 $10,000 $25,000
$300 $50,000 $3,500
A = $53,800
L + OE = $53,800

8. Expenses - Paid $1,000 to rent equipment for office.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

4 -200




-200

5 1,500






$1,500
6
$2,000





2,000
7 1,000 -1,000






8 -1,000






-1,000
bal $16,300 $1,000 $500 $10,000 $25,000
$300 $50,000 $2,500
A = $52,800
L + OE = $52,800

9. Expenses - Paid $400 in wages to part-time helper.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

4 -200




-200

5 1,500






$1,500
6
$2,000





2,000
7 1,000 -1,000






8 -1,000






-1,000
9 -400






-400
bal $15,900 $1,000 $500 $10,000 $25,000
$300 $50,000 $2,100
A = $52,400
L + OE = $52,400

10. Expense - Record utilities expense of $300 incurred in December but not yet paid.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

4 -200




-200

5 1,500






$1,500
6
$2,000





2,000
7 1,000 -1,000






8 -1,000






-1,000
9 -400






-400
10





300
-300
bal $15,900 $1,000 $500 $10,000 $25,000
$600 $50,000 $1,800
A = $52,400
L + OE = $52,400

11. Dividends - Declared and paid dividend of $600.

Assets = Liab. Owners' Equity

Cash A/R Supplies Land Building
A/P Common Stock Retained Earnings
1 $50,000





$50,000
2 -35,000

$10,000 $25,000

$50,000
3

$500


$500

4 -200




-200

5 1,500






$1,500
6
$2,000





2,000
7 1,000 -1,000






8 -1,000






-1,000
9 -400






-400
10





300
-300
11 -600






-600
bal $15,300 $1,000 $500 $10,000 $25,000
$600 $50,000 $1,200
A = $51,800
L + OE = $51,800

Practice Question 1

The collection of fees in cash when services are performed ______

A. increases assets and increases stockholders' equity.
B. increases assets and decreases assets.
C. decreases assets and decreases stockholders' equity.
Correct Answer: A

Collection of fees in cash when services are performed increases assets and increases stockholders' equity. Cash (an asset account) increases when cash is received and retained earnings (a stockholders' equity account) increases when revenue is earned.

Practice Question 2

The collection of an account receivable ______

A. increases assets and increases stockholders' equity.
B. increases assets and decreases assets.
C. decreases assets and decreases stockholders' equity.
Correct Answer: B

The collection of an account receivable increases an asset account (cash) and decreases an asset account (accounts receivable). Stockholders' equity or liabilities are not affected.

Practice Question 3

True or False? Decreases in both the cash and accounts payable accounts represent the payment of a liability.
Correct Answer: True

An asset account (cash) and a liability account (accounts payable) both decrease by the amount of the payment, and both sides of the accounting equation remain equal.

Practice Question 4

Arctic Air Company pays its supplier $100 toward a $500 purchase of supplies made the previous month on credit. The entry to record this transaction is debit ______

A. cash, $100 and credit accounts payable, $100.
B. cash, $100 and credit accounts receivable, $100.
C. accounts payable, $100 and credit cash, $100.
Correct Answer: C

The entry made at the time of purchase would have been debit Supplies, $500 and credit accounts payable, $500. Now the accounts payable account must be reduced by the $100 payment. The entry to record this payment is debit accounts payable, $100 and credit cash, $100.

Practice Question 5

When an expense is incurred, but will be paid in the future, the journal entry for this transaction includes a ______.

A. credit to accounts receivable
B. credit to accounts payable
C. debit to accounts receivable
Correct Answer: B

When an expense is incurred by a company, but has not yet been paid, a liability is created (amounts owed by the company to others). Liabilities are increased with credits. The journal entry for this transaction would include a debit to an expense account and a credit to accounts payable.

Practice Question 6

True or False? When dividends are declared and paid, the dividends account is debited and cash is credited.


Correct Answer: True

When dividends are declared and paid, assets are reduced and stockholders' equity is reduced. Cash is credited to reduce an asset account and dividends is debited to reduce stockholders' equity.

Practice Question 7

When a firm records income, net assets increase and ______

A. liabilities increase.
B. owners' equity increases.
C. liabilities decrease.
Correct Answer: B

On any given balance sheet, the total owners' equity is equal to the net assets, which is the difference between assets and liabilities. When income is recognized, net assets and owners' equity increase simultaneously.

Practice Question 8

The reason that both expenses and dividends are recorded by debit entries is that:

A. All dividend and expense transactions involve offsetting credit entries to the cash account.
B. Both expenses and dividends are offset against revenue in the income statement.
C. Both expenses and dividends reduce owners' equity.
D. This statement is untrue; expenses are recorded by debits but withdrawals are recorded by credits to the owner's drawing account.
Correct Answer: C

Practice Question 9

At the beginning of the year, Chock Company had $50,000 in assets and $20,000 in liabilities. At the end of the year, the company had $80,000 in assets and $40,000 in liabilities. If, during the year, no investments were made in the business and dividends of $2,000 were declared and paid during the year, net income for the year must have been ______.

A. $8,000
B. $10,000
C. $12,000
Correct Answer: C

Net income for the year was $12,000. Net income or loss (revenues less expenses) and dividends affect stockholders' equity. Stockholders' equity would have been $30,000 at the beginning of the year ($50,000 - $20,000) and $40,000 at the end of the year ($80,000 - $40,000). The change in stockholders' equity over the year was a $10,000 increase. If $2,000 was declared and paid in dividends, net income must have been $12,000 ($30,000 + $12,000 - $2,000 = $40,000).

Practice Question 10

Purchasing factory equipment on credit results in a debit to a(n) ______

A. asset account and a credit to a liability account.
B. liability account and a credit to an asset account.
C. expense account and a credit to a liability account.
Correct Answer: A

This transaction results in an increase to an asset account and an increase to a liability account. Assets are increased with debits and liabilities are increased with credits.