1.8: Transactions affecting the income statement and/or balance sheet

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To survive, a business must be profitable. This means that the revenues earned by providing goods and services to customers must exceed the expenses incurred.

In July 2010, Metro Courier, Inc., began selling services and incurring expenses. The explanations of transactions that follow allow you to participate in this process and learn the necessary accounting procedures.

1b. Earned service revenue and received cash

As its first transaction in July, Metro performed delivery services for customers and received USD 4,800 cash. This transaction increased an asset (cash) by USD 4,800. Stockholders’ equity (retained earnings) also increased by USD 4,800, and the accounting equation was in balance.

The USD 4,800 is a revenue earned by the business and, as such, increases stockholders’ equity (in the form of retained earnings) because stockholders prosper when the business earns profits. Likewise, if the corporation sustains a loss, the loss would reduce retained earnings.

Revenues increase the amount of retained earnings while expenses and dividends decrease them. (In this first chapter, we show all of these items as immediately affecting retained earnings. In later chapters, the revenues, expenses, and dividends are accounted for separately from retained earnings during the accounting period and are transferred to retained earnings only at the end of the accounting period as part of the closing process described in Chapter 4.) The effects of this USD 4,800 transaction on the financial position of Metro are:

Metro would record the increase in stockholders’ equity brought about by the revenue transaction as a separate account, retained earnings. This does not increase capital stock because the Capital Stock account increases only when the company issues shares of stock. The expectation is that revenue transactions will exceed expenses and yield net income. If net income is not distributed to stockholders, it is in fact retained. Later chapters show that because of complexities in handling large numbers of transactions, revenues and expenses affect retained earnings only at the end of an accounting period. The preceding procedure is a shortcut used to explain why the accounting equation remains in balance.

		Assets				=Liabilities +		Stockholders' Equity
Transaction	Explanation	Cash	AccountsReceivable	Trucks	Office Equipment	Accounts Payable	Notes Payabe	Capital + Stock	Retaind Earnings
	Beginning balances (Exhibit 2)	$ 13,500	$ -0-	$ 20,000	$ 2,500 =	$ -0-	$ 6,000	$ 30,000	$ -0-
1b	Earned service revenue and received cash	4,800							4,800
	Balances after transaction	$ 18,300		$ 20,000	$ 2,500 =		$ 6,000	+$30,000	$ 4,800
		Increased by $4,800							Increased by $4,800

2b. Service revenue earned on account (for credit)

Metro performed courier delivery services for a customer who agreed to pay USD 900 at a later date. The company granted credit rather than requiring the customer to pay cash immediately. This is called earning revenue on account. The transaction consists of exchanging services for the customer’s promise to pay later. This transaction is similar to the preceding transaction in that stockholders’ equity (retained earnings) increases because the company has earned revenues. However, the transaction differs because the company has not received cash. Instead, the company has received another asset, an account receivable. As noted earlier, an account receivable is the amount due from a customer for goods or services already provided. The company has a legal right to collect from the customer in the future. Accounting recognizes such claims as assets. The accounting equation, including this USD 900 item, is as follows:

		Assets				Liabilities		Stockholders' + Equity
Transaction	Explanation	Cash	Accounts Receivable	Trucks	Office Equipment	Accounts Payable	Notes Payable	Capital + Stock	Retained Earnings
	Balances before transaction	$ 18,300		$ 20,000	$ 2,500 =		$ 6,000	$ 30,000	$ 4,800
2b	Earned service revenue on account		$900						900
	Balances after transaction	$ 18,300	$900	$ 20,000	$ 2,500 =		$ 6,000	+ $30,000	$5,700
			Increased by $900						Increased by $900

3b. Collected cash on accounts receivable

Metro collected USD 200 on account from the customer in transaction 2b. The customer will pay the remaining USD 700 later. This transaction affects only the balance sheet and consists of giving up a claim on a customer in exchange for cash. The transaction increases cash by USD 200 and decreases accounts receivable by USD 200. Note that this transaction consists solely of a change in the composition of the assets. When the company performed the services, it recorded the revenue. Therefore, the company does not record the revenue again when collecting the cash.

		Assets				=Liabilities +	Stockholders' +Equity
Transaction	Explanation	Cash	Accounts Receivable	Trucks	Office Equipment	Accounts Payable Notes Payable	+ Capital Stock
	Balances before transaction	$ 18,300	$ 900	$20,000	$ 2,500 =	$ 6,000	$ 30,000
3b	Collected cash on account	$ 200	(200)
	Balances after transaction	$ 18,500	$700	20,000	$ 2,500 =	$ 6,000	+ $ 30,000
		Increased by $200	Decreased by $200

4b. Paid salaries

Metro paid employees USD 2,600 in salaries. This transaction is an exchange of cash for employee services. Typically, companies pay employees for their services after they perform their work. Salaries (or wages) are costs companies incur to produce revenues, and companies consider them an expense. Thus, the accountant treats the transaction as a decrease in an asset (cash) and a decrease in stockholders’ equity (retained earnings) because the company has incurred an expense. Expense transactions reduce net income. Since net income becomes a part of the retained earnings balance, expense transactions also reduce the retained earnings.

Assets				=Liabilities +		Stockholders' Equity
Cash	Accounts Receivable	Trucks	Office Equipment	Accounts Payable	Notes Payable +	Capital Stock	Retained Earnings
$18,500 (2,600)	$ 700	$ 20,000	$ 2,500 =		$6,000	$ 30,000	$ 5,700 (2,600)
$ 15,900	$ 700	$ 20,000	$ 2,500 =		$6,000 +	$ 30,000	$ 3,100
Decreased by $2,600							Decreased by $2,600

5b. Paid rent

In July, Metro paid USD 400 cash for office space rental. This transaction causes a decrease in cash of USD 400 and a decrease in retained earnings of USD 400 because of the incurrence of rent expense.

Transaction 5b has the following effects on the amounts in the accounting equation:

Assets				=Liabilities +		Stockholders' Equity
Cash	Accounts Receivable	Trucks	Office	Accounts	Notes	+ Capital Stock	Retained
			Equipment	Payable	Payable		Earnings
$15,900(400)	$ 700	$ 20,000	$ 2,500 =		$ 6,000	$ 30,000	$3,100(400)
$ 15,500	$ 700	$ 20,000	$ 2,500 =		$ 6,000	+ $ 30,000	$ 2,700
Decreased by $400							Decreased by $400

6b. Received bill for gas and oil used

At the end of the month, Metro received a USD 600 bill for gas and oil consumed during the month. This transaction involves an increase in accounts payable (a liability) because Metro has not yet paid the bill and a decrease in retained earnings because Metro has incurred an expense. Metro’s accounting equation now reads:

Assets				=Liabilities +		Stockholders'+Equity
Cash	Accounts Receivable	Trucks	Office Equipment	Accounts Payable	Notes Payable	Capital + Stock	Retained Earnings
$ 15,500	$ 700	$ 20,000	$ 2,500 =		$ 6,000	$ 30,000	$ 2,700
				600
$ 15,500	$ 700	$ 20,000	$ 2,500 ⁼	$ 600	$ 6,000	+ $30,000	$ 2,100

				Increased by $600			Decreased by $600

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