# Accounting Fundamentals

Students learn to record transactions and create basic financial statements using an Excel spreadsheet modeled after the accounting equation.

# Chapter 1: The Accounting Equation

Learning Objectives

By the end of this chapter, you will be able to:

• Utilize basic Excel functions
• Create a basic spreadsheet in Excel
• Understand key accounting principles
• Analyze transactions
• Determine how transactions impact the accounting equation
• Record transactions in a spreadsheet

The accounting equation represents the relationship between company assets and those who have a claim to those assets. Creditors have a claim to the assets of a business because they were promised payment in exchange for goods or services. Investors also have a claim to the assets of a business because they provided the capital (cash or property) that funded operations. If you were to liquidate (reduce to cash) all of the assets of the business and use the cash to settle (pay off) all of the business debts, the remaining cash would belong to the owners of the business and is referred to as equity. It is important to understand that it is the accountant’s job to keep track of claims to business assets, which arise as a result of business events and transactions.

Assets = Liabilities + Equity

Assets are the things the business owns, which includes claims to the assets of another business, entity, or person. Assets can be tangible, having a physical presence, such as Cash, Office Supplies, Equipment, Buildings, Land, etc. Assets can also be intangible, lacking a physical presence, such as Accounts Receivable, Notes Receivable, Goodwill, Patents, Copyrights, etc. When assets lack a physical presence, they are often represented by a document that is used to establish the asset’s existence. An invoice to a customer establishes the existence of Accounts Receivable. A promissory note establishes the existence of the Notes Receivable. The other intangible assets would be established with other forms of documentation.

It is important to note that the Assets are equal to the sum of Liabilities and Equity in the accounting equation. Liabilities are debts or obligations, which are amounts owed to others. Liabilities arise from credit relationships developed with other people, organizations, or businesses. Liabilities are one of three ways in which a business can acquire funding.

Equity is more precisely known as Owner’s Equity, Shareholder’s Equity, or Stockholder’s Equity. Equity is what the owners can claim after debt has been settled. Equity for the corporate form of business can take a few different forms such as Common Stock, Preferred Stock, Additional Paid-In Capital, and Retained Earnings. It can be thought of as what you own free of any debt obligations. For example, if a business owns \$100,000 in assets but owes \$30,000 to creditors, the equity to which owners/investors have a claim is \$70,000.

Assets = Liabilities + Equity

\$100,000 = \$30,000 + \$70,000

If the value of the business were to change, we could easily determine the change in the equity in the business. Assume that assets are now worth only \$120,000 and obligations total \$25,000. What is the equity balance? Simply manipulate the accounting equation to determine equity. By subtracting the liabilities from the assets, you derive the equity of \$95,000 for the business.

Assets - Liabilities = Equity

\$120,000 - \$25,000 = \$95,000

C1Q1

Which of the following is the accounting equation?

A

H2O

B

Assets = Cash + Accounts Receivable

C

Assets = Liabilities + Equity

D

Equity = Assets - Liabilities

The key to analyzing business transactions is understanding what parts of the accounting equation are affected when a transaction or event occurs. We already learned what assets are and what possible types of assets might exist for a business. We also learned what types of liabilities/debts might be incurred. Lastly, we learned that equity has several forms. We will take what we learned so far about the accounting equation and apply it to the analysis of business transactions.

The process of analyzing transactions and events means fitting them into the accounting equation (Assets = Liabilities + Equity). The asset side of the accounting equation must always equal the liability and equity side of the equation. This is accomplished through the use of double-entry bookkeeping, which is a process that requires the accountant to record a minimum of two entries (hence doubly-entry) per transaction or event. We keep the accounting equation in balance, meaning that the left and right side of the equals sign carry the same balance (amount),  by recording transactions that balance.  If each transaction is properly balanced when it is recorded, then the overall accounting equation should also be in balance. The sum of the left side must equal the sum of the right side. The job of the accountant is to determine which two or more items were affected by the transaction or event and then record it in the books. Both entries for the transaction or event can stay on the left side of the equals sign, meaning that two assets are affected. One entry can be on the left and the other entry is on the right side of the equals sign, which means an asset and a liability or equity is affected. Lastly, both entries could be on the right side of the equation, meaning that both entries affect some combination of liabilities and equity accounts. In summary, the transaction can stay on the left side of the equation, it can be split equally on both sides of the equation, or it can stay on the right side of the equation. We will see each of these possibilities several times throughout chapters one and two.

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Recall that double-entry bookkeeping requires us to record at least two entries. So far, we recorded one entry for \$15,000 to Cash on the left side of the accounting equation and the accounting equation is out of balance as depicted in the graphic above. We need to record \$15,000 to one other account as a decrease to an account on the left (asset) side of the equation or an increase to a liability or equity account on the right side of the equation. At this point, we can look back at the transaction sentence to see if there were other clues. Usually, the sentences are written with enough information to determine what other account was affected. 3. What did the business give up for the cash? Ownership interest in the business was given up for the cash. As a corporation, an investment is recorded in stock. When a corporation is formed, it can be assumed that Common Stock was issued because a corporation must be formed with common stock. If Common Stock was the account affected, 4. How was Common Stock affected? Was it a decrease in stock or an increase in stock? This is where you can deduce the correct answer by looking at the equation thus far. Because the

accounting equation must stay in balance and we know that it is an equity account called Common Stock, the Common Stock account must increase by \$15,000 for the equation to balance.

As we add transactions, we will expand the accounting equation, so it is easier to see how the standard accounting equation is affected by business transactions. Always start the transaction analysis by asking whether cash was involved. Then ask how cash was affected. Next, ask what other clue was given for the other account in the transaction. Lastly, ask how the account was affected. Many accounting transactions involve cash, which makes cash a good starting point for the analysis.

C1Q3

What is the first question you should ask when analyzing a business transaction?

A

What accounts are involved?

B

How were the accounts affected?

C

Did the cash account increase are decrease?

D

Was cash involved in the transaction?

2. Purchasing office supplies with cash. When starting a new business, it is often necessary to incur some startup costs. These costs are recorded using the cost principle, which simply means that assets and services acquired by the business should be recorded at their original acquisition cost also known as the historical cost. One such acquisition is the purchase of office supplies. Office supplies are items used to support the work performed around the office and in the field, such as pencils, pens, paper, paper clips, binders, folders, tape, staples, dispensers, etc. We do not always know how much office supplies will be used at any particular time, so we usually keep a small or modest amount of office supplies on hand. We record the initial purchase of office supplies as an asset that is used over time. Recording the purchase of supplies is straightforward. For example, Lucky Dog Inc. purchased \$300 of office supplies with cash. How would you record this transaction? Recall the deductive reasoning process discussed earlier. Start by asking the analysis questions previously discussed.

1. Was cash involved? We know cash was involved because it was stated in the transaction. 2. How was cash affected? Cash was decreased by \$300 because the cash was used to purchase the office supplies, which leads us to the next question. 3. What other account was affect by the transaction? The other item mentioned in the transaction was Office Supplies, which is another asset account. 4. How was Office Supplies affected? The account was increased by \$300 because the company acquired the additional supplies. Note that both items, Cash and Office Supplies, are assets, which means both entries are on the left side of the accounting equation where the net change was \$0.

Note that the individual accounts were affected so the transaction must be recorded; but there was no overall change to the equation because the increase and decrease occurred on the same side of the accounting equation. As long as the accounting equation remains in balance, transactions can be limited to accounts on either side of the equation.

C1Q4

Big Lake Motors purchased furniture with cash. Because cash is mentioned at the end of the transaction, we know cash is involved. What is the other account involved in the transaction?

3. Purchasing equipment with cash. Providing services requires an investment in long-term assets such as equipment, land, and buildings, etc. Fixed assets is a category of assets that are used over long periods of time. This is in contrast to short-term assets like office supplies that are usually used up in a month or so. A dog grooming salon requires specialized equipment to effectively handle dogs while providing grooming services. Assume Lucky Dog Inc. purchased specialized equipment for handling and grooming dogs by writing a check for \$5,000.

In this transaction, Lucky Dog Inc. wrote a check. It is important to understand that accountants do not distinguish between a check and cash because they are both deposited into or withdrawn from the same cash account. When you see a check, treat it like cash. In this situation, cash is again

involved because Lucky Dog Inc. wrote a check from the Cash account to purchase the equipment. Because cash was used to make the purchase, the Cash account was decreased by \$5,000 on the left side of the accounting equation to reduce the Cash account and the overall assets. Now we need to determine what other account was affected by the transaction. When making a purchase, it means an asset was acquired. In this case, we specifically purchased equipment, so the Equipment account was increased by \$5,000.

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4. Receiving deposits. Lucky Dog Inc. does not require a deposit before providing grooming services, but sometimes customers like to pay for several months of grooming services in advance. When this happens, the deposit must be treated as refundable until the services are performed. Because the cash was received for services not yet performed, it is treated as a liability. This is because the customer has a right to receive a refund of the deposit if the company is unable to perform the services for some reason. For example, in November 2015, Lucky Dog Inc. received \$900 cash for grooming services for two dogs over the next three months. As the service is performed the revenue will be recognized.

Ask the analyzing questions. Cash was involved. Cash increased by \$900. The other account used is more difficult to determine. Because Lucky Dog Inc. received an advance deposit and because it is

money owed to the customer until we complete the grooming services, we can name the other account Deposits Payable. This makes sense because it is a deposit received from a customer toward future services and it is refundable in the event we cannot perform the services. It is not revenue until we earn it later. In this case, Deposits Payable is increased by \$900. We will learn how to convert the deposit to revenue in chapter two.

C1Q6

A deposit is money received from a customer prior to having provided products or services. If the company is ultimately unable to provide the product or services, it will owe a refund to the customer. Which of the following is the best classification for a deposit received from a customer for future products or services.

A

a liability

B

an asset

C

a revenue

D

an expense

5. Paying deposits. Some assets are purchased before they are needed and with the intent of using or consuming them over a short period of time. These are prepaid assets. In the accounting profession, they are commonly referred to as prepaid expenses. I feel this is a confusing name because they are not yet expenses. A better name is prepaid assets. Think of it like a prepaid phone card. The phone card is the asset you purchased with cash. The expense is not incurred until the phone card is used to make a phone call. A prepaid insurance policy works the same way. A company might purchase liability insurance to protect the business against financial losses resulting from accidents that may occur on the company grounds, such as a customer slipping on a wet floor or tripping over a box in a store isle. Assume Lucky Dog Inc. purchased a one-year liability insurance policy and paid the annual premium of \$2,400 by check in November 2018. The insurance policy starts November 1, 2018 and ends October 31, 2019.

Recall that a check is considered cash. This transaction resulted in a decrease of Cash by \$2,400 on the left side of the accounting equation. The other account affected was also an asset, specifically a prepaid asset. Because we prepaid an entire year of insurance, we can call the asset Prepaid Insurance. The balance in the Prepaid Insurance account increased by the amount of the annual policy premium, \$2,400. Because the asset side of the equation experienced both an increase and a

decease, the accounting equation remains in balance. We will learn how to convert the insurance policy to an expense in chapter two.

C1Q7

When a deposit is received from a customer, it is recorded as a liability. When deposit is paid by the company to another entity, the deposit is recorded as an asset. Based on this information, which of the following statements is true about recording the payment of a deposit?

A

Cash is an asset. Whatever you spend cash on is also going to be an asset.

B

We consider a deposit paid to another entity to be our money until we receive a product or services. Because it is still our money, we classify it as an asset until the deposit is used.

C

The payment of a deposit should be classified as a liability.

D

No entry is required when you pay a deposit.

6. Purchasing Short-Term Investments. If the business possesses a large amount of money that will be needed over the course of a year or less, it could be invested on a short-term basis in a money-market account so interest could be earned while waiting for management to use the money to fund some part of operations or a different project. A short-term investment like a money-market account is highly liquid and is considered a cash equivalent. Liquidating an asset means to convert it to cash by selling it. Some short-term investments are considered highly liquid because they can quickly be converted to cash when needed (in 90 days or less). A money-market account allows the investor to draw on the funds at any time; so it is treated like cash, which is referred to as a cash equivalent. Assume management at Lucky Dog Inc. decided to invest \$2,500 in a money-market fund to earn interest on money that was not immediately needed for operations.

Cash was involved in this transaction. The other account was the Money Market account. Because the money-market fund was highly liquid (like cash) it was placed next to Cash. The Cash account was decreased by \$2,500 and the Money Market account was increased by \$2,500. Because both accounts

are assets, both entries were made to the left side of the accounting equation. We essentially traded one asset for another asset. The net effect on the accounting equation was zero and the equation remains in balance.

7. Borrowing money (promissory notes). When money is borrowed, a promissory note is signed by both parties to formally acknowledge the loan and its payment terms. This is essentially a financial contract in which the borrower promises to pay back the principal plus interest to the creditor. Because we are recording the promissory note from the business perspective, the debt must be recorded as a Note Payable, indicating that the note must be paid back to the bank over time. Because Lucky Dog Inc. is a new startup with no credit history, the business presents more than the normal lending risk to the bank. Sometimes venture capitalists will loan money at a moderate interest rate or they will ask for an equity stake (an ownership percentage) of the business. It is also possible to open a business using a credit card for financing, which would be a versatile form of credit. It is even possible to borrow funds from individuals such as friends or relatives, but I would consider this the least attractive option because it is not a good idea to mix family/friends with business. If none of these options are appealing, the Small Business Administration (SBA) may have options. The SBA is a government agency established to provide assistance to small businesses. The SBA has several loan programs. Whether money is borrowed from a bank, a venture capitalist, or the SBA, a promissory note is required. In this case, Lucky Dog Inc. borrowed \$10,000 from the SBA, signing a three-year promissory note at 8% APR.

Recording this transaction in the worksheet is very similar to the previous transaction. We know that Cash was involved, because we borrowed it from the SBA. Cash increased by the amount borrowed, \$10,000. Because the company’s debt to the SBA increased upon signing the promissory note and taking the cash, the Notes Payable account also increased by \$10,000. This time, the entries are on

different sides of the accounting equation (separated by the equals sign). For the accounting equation to stay in balance, both sides increased.

8. Purchasing long-term investments. Some debts come with covenants, which are requirements of the debt agreement. The loan from the SBA came with a covenant. A positive covenant is a requirement that the debtor engage in a specific activity stipulated in the debt agreement. A negative covenant is a requirement that the debtor not engage in a specific activity stipulated in the debt agreement. The SBA required that management at Lucky Dog Inc. set 10% of the borrowed funds aside in a restricted account. This means 10% of the borrowed funds cannot be spent. The SBA may have included this requirement to force Lucky Dog Inc. to carefully manage its cash flows. There are two separate requirements in this example. The positive covenant is the requirement that 10% of the funds be placed in a restricted account. The negative covenant forbids management to spend the restricted funds. A restricted account is an account designated for a specific purpose. In this case, management at Lucky Dog Inc. decided to invest the funds in a five-year CD (certificate of deposit) that would mature when the SBA loan was to be repaid. This way, the money cannot be spent and the company is earning interest on it. Lucky Dog Inc. purchased a \$1,000 CD at the bank.

Cash was used to purchase the CD, resulting in a decrease to Cash by \$1,000. The item purchased was a CD, which is a financial investment. Investments are a form of asset, so the second entry should be an increase to the Investment – CD account by \$1,000. Because the CD for more than a year, it is

considered long-term and should be place close to the other long-term assets, such as Equipment.

### Accounting for Petty Cash

9. Establishing a petty-cash fund. It is common practice to keep a small amount of money in a locked drawer for small purchases for which a company check might be impractical or inconvenient. For example, what if the cashier at Lucky Dog Inc. ran out of receipt paper during business hours and needed to make an emergency run to the office supply store across the street to purchase a small box of receipt paper. It might not be practical to get the receipt paper through the normal channels because customers are waiting, so the cashier sends another employee with \$10 from the petty-cash fund to buy the receipt paper. The employee must remember to bring back the receipt for the purchase and the change. The receipts supporting use of the petty-cash would be tallied and submitted to the accountant or bookkeeper once a month for reimbursement of the petty-cash fund. Assume management at Lucky Dog Inc. established a petty-cash drawer in the amount of \$200.00.

Though it is cash, petty cash is accounted for separately from the Cash account. Petty cash is a liquid asset, which means it should be listed next to the cash account. Establishing petty cash is done by cashing a check drawn on the business checking account and placing the cash in a locked drawer. We are simply moving the amount from one asset account to another. Recording the event requires a reduction of the Cash account by \$200 and an increase in the Petty Cash account by \$200. Because

both accounts are assets, both entries were made to the left side of the accounting equation. The net effect on the equation was zero and the equation remains in balance.

10. Increasing the petty-cash fund.  The petty-cash account can be increased or decreased as needed. Increasing the petty cash requires writing another check and cashing it at the bank. Then place the additional cash in the locked petty-cash drawer. Assume management at Lucky Dog Inc. increased the petty cash by \$100.

The entry to increase petty cash is the same as establishing it. In this case, the Cash account was decreased by \$100 and the Petty-Cash account was increased by \$100. Again, both accounts are

assets; so both entries were made to the left side of the accounting equation. The net effect on the equation was zero and the equation remains in balance.

11. Decreasing the petty-cash fund. It is sometimes necessary to decrease the amount of petty cash. The amount of petty cash should be minimal to discourage misuse of it. If it is later determined that the amount of petty cash is too high, it can be reduced by simply depositing the excess cash back into the business checking account. Assume that management at Lucky Dog Inc. decided to reduce petty cash by \$50.

This time, Cash is increased by \$50 because the petty cash was deposited into the business checking account. The Petty-Cash account is then decreased by \$50. This event represents a simple transfer of

money from one asset account to another asset account. Like last time, both accounts are assets; so both entries were made to the left side of the accounting equation. The net effect on the equation was zero and the equation remains in balance.

### Retained Earnings

There are three ways in which a company can raise funds and we will pay a lot of attention to Retained Earnings in this chapter. I mentioned earlier that borrowing was one way in which a business could raise funds/acquire funding. I also mentioned that funds could be raised by issuing stock. The third way a business raises funds is through Retained Earnings, which is the result of operations, which is what the company is in business to do. For example, an accounting firm will raise funds by providing accounting services and collecting payment from customer. Retained earnings is an equity account that reflects revenues, expenses, and dividends. Revenues increase retained earnings. Expenses and dividends decrease retained earnings. It is interesting to note that Revenues, Expenses, and Dividends when listed in this order spell RED. It can be a useful to remember that the RED accounts are retained earnings. The concept of retained earnings will become clear as we work through some transactions.

### Earning Revenues

Revenue is what the business earns through its normal operations. Revenue can be earned by providing services (Service Revenue) or selling a product (Sales Revenue). For example, an accounting firm will provide accounting services during its normal operations. A department store (retailer) will purchase inventory from a manufacturer or distributor and markup the products to sell to others for a profit during its normal operations. We will start with Service Revenue in this chapter and explore Sales Revenue for retailers in the next chapter.

C1Q8

What word is used to remind students which accounts that are closed during the closing process?

12. Providing services for cash.  It is important to note that accountants record all cash and check transactions exactly the same way. It does not matter whether the transaction states that cash was received from the customer or whether a check was received from the customer, it is all recorded as cash. This is because both cash and checks are deposited into the same bank account, which is simply referred to as the Cash account. For example, assume Lucky Dog Inc. provided grooming services to customers during the month for a total of \$3,700, receiving cash and checks as payment.

To analyze this transaction, recall that it does not matter whether Lucky Dog Inc. received cash or a check from the customer, both are treated as cash. This means Cash was involved in the transaction and it increased by \$3,700 because we received it from the customer at the time services were provided. The other account affected was Service Revenue, which increased by \$3,700 because we performed grooming services. It may be helpful to note that revenue accounts should always

increase. There is almost no reason to decrease revenue accounts except to correct a minor error in a subsequent (later) period. As a general rule, revenues always increase because of their increasing effect on retained earnings.

### Incurring Expenses

Expenses are amounts incurred during the pursuit of revenues. Even a simple form of business with only one employee incurs expenses. For example, an accountant who prepares tax returns for a living incurs a number of expenses before charging the client for the work performed. Paper and other supplies are needed to complete the returns. Office space needs to be rented and furniture purchased for interviewing clients and doing the work. The expenses add up quickly. Some other common examples of business expenses include Salaries, Wages, Utilities, Advertising, and Postage. This is a very short list. As a business grows, the list of expenses usually gets longer and the amounts get bigger. Lucky Dog Inc. is still a small business, so there are only a few expenses at this time. Expenses have the opposite effect on retained earnings that revenues have. As expenses increase, they reduce retained earnings. The overall effect of an expense is a decrease of the right side of the accounting equation, which is why the amounts for expenses are entered as negative in the worksheet.

13. Paying rent with cash. Assume that the rental lease was signed by the management at Lucky Dog Inc. on November 2 and a check was given to the landlord for the first month’s rent at that time. Lucky Dog Inc. paid the first month’s rent of \$600. In the future, the rent check will be mailed.

Operating expenses such as rent are usually paid by check, but the entry is to the cash account. We know that cash was involved in this transaction because we paid the rent. When the words pay or paid are used, cash is implied. The Cash account decreased by \$600. To figure out the other side of the equation, we revisit the transaction. What does it say was paid? Rent! Rent Expense is on the right

side of the equation as part of retained earnings. Recall that expenses decrease retained earnings, so the amount should be entered as -\$600 under rent expense.

14. Replenishing petty cash. So far, the only item for which petty cash should be replenished is the purchase of the receipt paper in an earlier example. To accomplish this, submit the petty-cash record to accounting noting the date, item purchased, purpose of the purchase, amount, and attached receipt. Assume that management at Lucky Dog Inc. authorized use of petty cash to purchase a total of \$35 in grooming supplies and \$9 for office supplies, all of which was needed at the last minute and immediately used in the grooming parlor. The total for petty cash used during the month was \$44 as confirmed by the receipts and the petty cash balance was short \$1.

In this case, the amount needed to replenish petty cash is \$45, which includes the dollar that was lost sometime during the month. The replenishing of petty cash should be entered as an efficient entry. This means all entries are on the same line of the accounting worksheet. The petty-cash fund is reimbursed from cash, so cash in involved. We are moving funds from Cash to Petty Cash by writing a check, cashing the check at the bank, and placing the \$45 in the petty-cash drawer. No entry is made to the Petty Cash account when replenishing it, only when establishing petty cash, increasing the amount of petty cash, or decreasing the amount of petty cash. Cash is decreased by the total amount

needed of \$45. Because expenses have a decreasing effect on retained earnings, the other entries are to Grooming Supplies Expense for -\$35, Office Supplies Expense for -\$9, and Cash Over/Short Expense for -\$1.

C1Q9

Which of the following will not result in an entry to the petty-cash account?

A

an increase in pettycash

B

a decrease in petty cash

C

establishing petty cash

D

replenishing petty cash

15. Paying Dividends. One way in which an owner or investor in a business may be compensated is by receiving a dividend, which is a direct withdrawal of cash from the business. Dividends decrease retained earnings like expenses do, though dividends are not expenses. An expense is incurred during operations, in support of the pursuit of revenues. Dividends are payments from the profits to the owner(s) of the business. Because dividends decrease the cash available to operate the business, companies must be careful not to pay dividends when the business is experiencing a cash shortage. The management at Lucky Dog Inc. is aware of this concern, which is why Lucky Dog Inc. issued only a small dividend of \$500 during the first half of the month.

Because this is a cash dividend, we already know that cash is involved. We also know that the payment of the cash dividend decreases the Cash account by \$500 on the left side of the accounting equation. The other account mentioned in the event was dividends. Because dividends behave like

expenses, we expect to see the reducing effect of dividends on the overall retained earnings of the business. Reducing retained earnings means entering -\$500 for the Dividends account.

C1Q10

Which of the following is not a RED account?

A

Dividends

B

Retained Earnings

C

Service Revenue

D

Salaries Expense

### Summary

Understanding the accounting process starts with the accounting equation. Everything a business does can be recorded in an expanded accounting equation within an Excel spreadsheet. Remember to start with the question about cash.  Then ask what was gained or given up in exchange for the cash.  Recall that the accounting equation must stay in balance. If you keep each transaction in balance, the accounting equation will always balance.

### Challenge Questions

1. Why is it important for a business person to understand accounting?

2. Why is it important for a business owner to know the numbers (understand the financial statement)?

3. Why is it important to learn Excel?

4. What other ways can you learn about accounting or Excel other than this text?

5. Why is it important to have good controls over cash?

Credits: The exhibits, photos, and videos were created by the author.