Learn how to conduct an analysis of business transactions.
- Individual transactions impacting income can be analyzed using the expanded accounting equation, which is assets equal liabilities, plus paid-in capital, plus revenues, minus expenses, minus dividends. Transaction analysis makes use of this expanded accounting equation to critically and systematically analyze the impact of a business event on a company's reported financial performance and position. The analysis of transactions undertaken on the first day of business for the hypothetical company, Veda Landscape Solutions, is summarized here.
Notice from these transactions that Veda hasn't actually done any business yet. All of the transactions considered thus far have been just preparation for doing business. As a result, no sales have yet been made and no expenses have yet been incurred. Analysis of revenue and expense transactions requires the use of this expanded accounting equation, let's remind ourselves, assets equal liabilities, plus paid-in capital, plus revenues, minus expenses, minus dividends. The insight behind this expanded accounting equation is that equity can be decomposed into paid-in capital and retained earnings, and that revenues, expenses, and dividends are just temporary subcategories of retained earnings.
This expanded accounting equation will be used to analyze the following additional events during the first year of business for Veda Landscape Solutions. Transaction number seven, purchased additional inventory items for retail resale for a total of $1,300,000. The entire amount was put on supplier's accounts. So, not cash was paid at the time of purchase. Transaction eight, sold inventory costing $800,000 to retail customers for $1,100,000.
The customers paid $200,000 in cash and the remaining $900,000 was put on the customers' accounts. The impact of each of these events on Veda's income statement and balance sheet is illustrated in the spreadsheet. Here is a description of the analysis of each item. Transaction number seven, the inventory account is increased by $1,300,000 because Veda has more inventory. Also, because the inventory was purchased entirely on account, the amount of accounts payable has also increased by $1,300,000.
Transaction eight, as a result of this business transaction, Veda has added two asset accounts, an increase of cash of $200,000 and an increase in the asset accounts receivable of $900,000. These assets were not borrowed, they were not invested. Instead, they were generated in the course of doing business. When assets come into a business in this way, their source is recorded as revenue. In this case, the account sales revenue is increased by $1,100,000.
The sales revenue account is a subcategory of retained earnings and represents an increase in the equity of the business that has occurred because of conducting business operations. In exchange for the cash in accounts receivable, Veda had to give up inventory costing $800,000. This is reflected by reducing the asset inventory by $800,000. This asset was consumed in the course of business operations. So, what is also reflected as the expense, cost of goods sold? The $800,000 amount under cost of goods sold is shown as a subtraction because it represents a reduction in equity.
As with the sales revenue account, the cost of goods sold expense account, is a subcategory of retained earnings. When put together, the $1,100,00 equity increase, recorded as sales revenue, and the $800,000 equity decrease, recorded as cost of goods sold, means that this operating transaction increased the equity of the business by $300,000. That's the $1,100,000 minus the $800,000. The key points to remember concerning the recording of revenues and expenses, is that revenues increase and expenses decrease the retained earnings portion of equity.
Stay tuned for Part 2 of the training series, which covers ratio analysis, forecasting, and business valuation.
- Explain the equality required in the basic accounting equation.
- Recall why accounts payable are considered Current Liabilities.
- Identify which financial statement can be described as a “snapshot” of a company’s final position.
- Name the term used to refer to a company where the Operating Cash exceeds the investing and Financing activities.
- Identify the result of entering a debit in an expense account.
- Name the account that is closed at the end of the year.