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1.6: Transaction Analysis and Double-entry Accounting

  • Page ID
    • Henry Dauderis and David Annand
    • Athabasca University via Lyryx Learning
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    learning objective

    1. Analyze transactions by using the accounting equation.

    The accounting equation is foundational to accounting. It shows that the total assets of a business must always equal the total claims against those assets by creditors and owners. The equation is expressed as:


    Figure \(\PageIndex{1}\)

    When financial transactions are recorded, combined effects on assets, liabilities, and equity are always exactly offsetting. This is the reason that the balance sheet always balances.

    Each economic exchange is referred to as a financial transaction — for example, when an organization exchanges cash for land and buildings. Incurring a liability in return for an asset is also a financial transaction. Instead of paying cash for land and buildings, an organization may borrow money from a financial institution. The company must repay this with cash payments in the future. The accounting equation provides a system for processing and summarizing these sorts of transactions.

    Accountants view financial transactions as economic events that change components within the accounting equation. These changes are usually triggered by information contained in source documents (such as sales invoices and bills from creditors) that can be verified for accuracy.

    The accounting equation can be expanded to include all the items listed on the Balance Sheet of Big Dog at January 31, 2015, as follows:


    Figure \(\PageIndex{2}\)

    If one item within the accounting equation is changed, then another item must also be changed to balance it. In this way, the equality of the equation is maintained. For example, if there is an increase in an asset account, then there must be a decrease in another asset or a corresponding increase in a liability or equity account. This equality is the essence of double-entry accounting. The equation itself always remains in balance after each transaction. The operation of double-entry accounting is illustrated in the following section, which shows 10 transactions of Big Dog Carworks Corp. for January 2015.


    Figure \(\PageIndex{3}\)


    Figure \(\PageIndex{4}\)


    Figure \(\PageIndex{5}\)

    These various transactions can be recorded in the expanded accounting equation as shown below:


    Figure \(\PageIndex{6}\): Transactions Worksheet for January 31, 2015

    Transactions summary:

    1. Issued share capital for $10,000 cash.
    2. Received a bank loan for $3,000.
    3. Purchased equipment for $3,000 cash.
    4. Purchased a truck for $8,000; paid $3,000 cash and incurred a bank loan for the balance.
    5. Paid $2,400 for a comprehensive one-year insurance policy effective January 1.
    6. Paid $2,000 cash to reduce the bank loan.
    7. Received $400 as an advance payment for repair services to be provided over the next two months as follows: $300 for February, $100 for March.
    8. Performed repairs for $8,000 cash and $2,000 on credit.
    9. Paid a total of $7,100 for operating expenses incurred during the month; also incurred an expense on account for $700.
    10. Dividends of $200 were paid in cash to the only shareholder, Bob Baldwin.

    The transactions summarized in Figure 1.7.6 were used to prepare the financial statements described earlier, and reproduced in Figure 1.7.7 below.


    Figure \(\PageIndex{7}\): Financial Statements of Big Dog Carworks Corp.

    Accounting Time Periods

    Financial statements are prepared at regular intervals — usually monthly or quarterly — and at the end of each 12-month period. This 12-month period is called the fiscal year. The timing of the financial statements is determined by the needs of management and other users of the financial statements. For instance, financial statements may also be required by outside parties, such as bankers and shareholders. However, accounting information must possess the qualitative characteristic of timeliness — it must be available to decision makers in time to be useful — which is typically a minimum of once every 12 months.

    Accounting reports, called the annual financial statements, are prepared at the end of each 12-month period, which is known as the year-end of the entity. Some companies' year-ends do not follow the calendar year (year ending December 31). This may be done so that the fiscal year coincides with their natural year. A natural year ends when business operations are at a low point. For example, a ski resort may have a fiscal year ending in late spring or early summer when business operations have ceased for the season.

    Corporations listed on stock exchanges are generally required to prepare interim financial statements, usually every three months, primarily for the use of shareholders or creditors. Because these types of corporations are large and usually have many owners, users require more up-to-date financial information.

    The relationship of the interim and year-end financial statements is illustrated in Figure 1.7.8.


    Figure \(\PageIndex{8}\): Relationship of Interim and Year-end Financial Statements

    This page titled 1.6: Transaction Analysis and Double-entry Accounting is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by Henry Dauderis and David Annand (Lyryx Learning) .

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