This is “Understanding the Effects Caused by Common Transactions”, section 4.2 from the book Business Accounting (v. 2.0). For details on it (including licensing), click here.

For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (20 MB) or just this chapter (1 MB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).

Has this book helped you? Consider passing it on:
Creative Commons supports free culture from music to education. Their licenses helped make this book available to you.
DonorsChoose.org helps people like you help teachers fund their classroom projects, from art supplies to books to calculators.

4.2 Understanding the Effects Caused by Common Transactions

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Explain the reason that a minimum of two accounts are impacted by every transaction.
  2. Identify the individual account changes that are created by the payment of insurance and rent, the sale of merchandise, the acquisition of a long-lived asset, a capital contribution, the collection of a receivable, and the payment of a liability.
  3. Separate the two events that occur when inventory is sold and determine the financial effect of each.

Recording the Sale of Inventory

Question: Transaction 4—Assume that the inventory items bought in Transaction 1 for $2,000 are now sold to a customer for $5,000 on credit. What account balances are impacted by the sale of merchandise in this manner?

 

Answer: Two connected events actually take place in the sale of inventory. First, revenue of $5,000 is generated by the sale. This account is frequently labeled as “Sales” or “Sales revenue.”

In this example, because the money will not be collected until a later date, accounts receivable (an asset) is initially increased. The reporting of a receivable balance indicates that this amount of money is due from a customer and should be collected at some subsequent point in time.

Transaction 4, Part 1: Sale Occurs on Credit Accounts Receivable (asset) increases by $5,000 Sales (revenue) increases by $5,000

Second, the inventory is removed. Companies have an option in the method by which inventory balances are monitored. Here, a perpetual inventory systemAccounting system that maintains an ongoing record of all inventory items both in total and individually; records increases and decreases in inventory accounts as they occur as well as the cost of goods sold to date. is utilized. That approach is extremely common due to the prevalence of computer systems in the business world. It maintains an ongoing record of the inventory held and the amount that has been sold to date. All changes in inventory are recorded immediately. However, in a later chapter, an alternative approach—still used by some smaller businesses—known as a periodic inventory systemAccounting system that does not maintain an ongoing record of all inventory items; instead, ending inventory is determined by a physical count so that a formula (beginning inventory plus purchases less ending inventory) can be used to calculate cost of goods sold. will also be demonstrated.

Because a perpetual system is used here, the reduction in inventory is recorded simultaneously with the sale. Inventory costing $2,000 is taken away by the customer. The company’s net assets are reduced by this amount. Therefore, a $2,000 expense is recognized. That inventory no longer provides a future benefit for the company but rather is a past benefit. Cost of goods sold is reported to reflect this decrease in the amount of merchandise on hand.

Transaction 4, Part 2: Inventory Acquired by Customer Cost of Goods Sold (expense) increases by $2,000 Inventory (asset) decreases by $2,000

As discussed in the previous chapter, the $3,000 difference between the sales revenue of $5,000 and the related cost of goods sold of $2,000 is known as the gross profit (or gross margin or mark up) on the sale.

Test Yourself

Question:

The Hashan Company buys inventory for $7,000 that it eventually sells to a customer for $8,000 in cash. The company’s accountant increases cash by $8,000, reduces inventory by $7,000, and records a “gain on sale of inventory” for $1,000. Which of the following statements is true?

  1. The company’s reported net income is stated properly.
  2. The company’s reported revenues are too high.
  3. The company’s reported expenses are too high.
  4. All reported figures are properly stated.

Answer:

The correct answer is choice a: The company’s reported net income is stated properly.

Explanation:

The company should have recognized revenues of $8,000 and a cost of goods sold of $7,000 so that a gross profit of $1,000 would be reported on the company’s income statement. Both the revenue and the expense were omitted and are too low. Instead, a gain of $1,000 was recorded. That gain has the same impact as the $1,000 gross profit, so net income was not affected by the mistake.

The Dual Effect of Transactions

Question: In each of the events studied so far, two accounts have been affected. Are two accounts impacted by every possible transaction?

 

Answer: In every transaction, a cause-and-effect relationship is always present. For example, the accounts receivable balance increases because of a sale. Cash decreases as a result of paying salary expense. Cost of goods sold increases because inventory is removed. No account balance can possibly change without some identifiable cause. Thus, every transaction must touch a minimum of two accounts. Many transactions actually affect more than two accounts but at least two are impacted by each of these financial events.

Paying a Previously Recorded Expense

Question: Transaction 5—In this transaction, the reporting company pays $700 for insurance coverage relating to the past few months. The information provided indicates that the cost was previously recorded in the company’s accounting system as incurred. Apparently, the computers were programmed to accrue this expense periodically. What is the financial impact of paying an expense if the balance has already been recognized over time as the liability grew larger?

 

Answer: Several pieces of information should be noted in analyzing this example.

  • Cash declined by $700 as a result of the payment.
  • This cost relates to a past benefit. Thus, an expense must be recorded. No future economic benefit is created by the insurance payment. Cash was paid for coverage over the previous months.
  • The company’s accounting system has already recorded this amount. Thus, $700 in insurance expense and the related liability were recognized as incurred. This is clearly a different mechanical procedure than that demonstrated in Transaction 2 for the salary payment.

The expense cannot be recorded again or it will be double counted. Instead, cash is reduced along with the liability that was established through the accrual process. The expense was recorded already so no additional change in that balance is needed. Instead, the liability is removed and cash decreased.

Transaction 5: Payment of Amount Owed for Insurance Insurance Payable (liability) decreases by $700 Cash (asset) decreases by $700

Note that accounting recognition is dependent on the recording that has already taken place. The final results to be reported should be the same (here an expense is recognized and cash decreased), but the steps in the process can vary.

Test Yourself

Question:

Sara Frances is the accountant for National Lumber Company of Cleveland. She receives an invoice for three months’ rent for one of the warehouses that the company uses. This bill is for $3,000 per month, or $9,000 in total. The check is written, and Ms. Frances is getting ready to record the payment but is not sure whether the expense has been previously accrued. Which one of the following statements is not true?

  1. If the expense has been accrued, a rent payable balance of $9,000 should be present in the accounting records.
  2. If the expense has not been accrued, no rent payable balance should currently be present in the accounting records.
  3. If the expense has been accrued, the net income figure should already be properly stated before the payment is recorded.
  4. If the expense has not been accrued, a liability will need to be established when the payment is recorded.

Answer:

The correct answer is choice d: If the expense has not been accrued, a liability will need to be established when the payment is recorded.

Explanation:

If the accounting system recognized the rent as it accrued, the expense balance and the related liability have already been recorded. The expense recognition means that net income can be determined appropriately based on the reported balances. If no accrual has been recorded to date, there is neither an expense nor a liability. At the time of payment, cash is decreased and the expense is recorded. Because the liability was never entered into the records, no change is made in that balance.

Acquisition of an Asset

Question: Transaction 6—According to the original information, a truck is acquired for $40,000, but only $10,000 in cash is paid by the company. The other $30,000 is covered by signing a note payable. This transaction seems a bit more complicated because more than two accounts are involved. What is the financial impact of buying an asset when only a portion of the cost is paid on that date?

 

Answer: In this transaction, for the first time, three accounts are impacted. A truck is bought for $40,000 so the balance recorded for this asset is increased by that cost. Cash decreases $10,000 while the notes payable balance rises by $30,000. These events each happened. To achieve a fair presentation, the accounting process seeks to reflect the actual occurrences that took place. As long as the analysis is performed properly, recording a transaction is no more complicated when more than two accounts are affected.

Transaction 6: Acquisition of Truck for Cash and a Note Truck (asset) increases by $40,000 Cash (asset) decreases by $10,000 Notes Payable (liability) increases by $30,000

Recording a Capital Contribution by an Owner

Question: Transaction 7—Assume that several individuals approach the company and offer to contribute $19,000 in cash to the business in exchange for capital stock so that they can join the ownership. The offer is accepted. What accounts are impacted by the issuance of capital stock to the owners of a business?

 

Answer: When cash is contributed to a company for a portion of the ownership, cash obviously goes up by the amount received. This money was not generated by revenues or by liabilities but rather represents assets given freely so that new ownership shares could be obtained. This inflow is reflected in financial accounting as increases in both the cash and capital stock accounts. Outside decision makers can see that this amount of the company’s net assets came from investments made by owners.

 

 

Transaction 7: Cash Contributed in Exchange for Capital Stock Cash (asset) increases by $19,000 Capital Stock (stockholders’ equity) increases by $19,000

Test Yourself

Question:

The Hamilton Company issues capital stock to new owners in exchange for a cash contribution of $34,000. The company’s accountant thought the money came from a sale and recorded an increase in cash and an increase in revenue. Which of the following statements is not true as a result of this recording?

  1. The company’s assets are overstated on the balance sheet.
  2. The company’s net income is overstated on the income statement.
  3. The company’s capital stock account is understated on the balance sheet.
  4. The company’s expenses are correctly stated on the income statement.

Answer:

The correct answer is choice a: The company’s assets are overstated on the balance sheet.

Explanation:

The company should have increased cash, and it did, so that balance (as well as the other assets) is properly stated. The revenue balance was overstated, so that reported net income is also overstated. The capital stock account should have been increased but was not, so it is understated. Expenses were not affected by either the transaction or the recording, so that total is correct.

The Collection of an Account Receivable

Question: Transaction 8—A sale of merchandise was made previously in Transaction 4 for $5,000. No cash was received at that time, but the entire amount is collected now. What accounts are affected by the receipt of money from an earlier sale?

 

Answer: The revenue from this transaction was properly recorded in Transaction 4 when the sale originally took place and the account receivable balance was established. Revenue should not be recorded again or it will be double counted, causing reported net income to be overstated. In simple terms, revenue is recorded when earned, and that has already taken place. Instead, for recording purposes, the accountant indicates that this increase in cash is caused by the decrease in the accounts receivable balance established in Transaction 4.

Transaction 8: Collection of Account Receivable Cash (asset) increases by $5,000 Accounts Receivable (asset) decreases by $5,000

Payment Made on an Earlier Purchase

Question: Transaction 9—Inventory was bought in Transaction 1 for $2,000 and later sold in Transaction 4. Now, however, the company is ready to make payment of the amount owed for this merchandise. When cash is delivered to settle a previous purchase of inventory, what is the financial effect of the transaction?

 

Answer: As a result of the payment, cash is decreased by $2,000. The inventory was recorded previously when acquired. Therefore, this subsequent transaction does not replicate that effect. Instead, the liability established in number 1 is now removed from the books. The company is not buying the inventory again but simply paying off the debt established for these goods when they were purchased.

Transaction 9: Payment of a Liability for a Purchase Accounts Payable (liability) decreases by $2,000 Cash (asset) decreases by $2,000

Test Yourself

Question:

A company buys inventory for $10 on Monday on account. The company sells the inventory for credit on Tuesday for $12. The company pays for the inventory on Wednesday. The company collects the money from the sale on Thursday. On which day or days does this company increase its net assets (assets minus liabilities)?

  1. All four days
  2. Tuesday only
  3. Tuesday and Wednesday
  4. Wednesday and Thursday

Answer:

The correct answer is choice b: Tuesday only.

Explanation:

No change in net assets occurs on Monday, Wednesday, or Thursday. Buying inventory (Monday) increases inventory but also accounts payable, so the net asset total is unchanged. Paying for inventory (Wednesday) decreases cash but also accounts payable. Collecting for the sale (Thursday) increases cash but also decreases accounts receivable. No change in net assets takes place except for the sale on Tuesday. The sale causes an increase in net assets that is the equivalent of the gross profit.

Payment of Rent in Advance

Question: Transaction 10—The company wants to rent a building to use for the next four months and pays the property’s owner $4,000 to cover this cost. When payment is made for rent (or a similar cost) with a future economic benefit, what recording is appropriate in financial accounting?

 

Answer: In acquiring the use of this property, the company’s cash decreases by $4,000. The money was paid to utilize the building for four months in the future. The anticipated economic benefit is an asset, and that information should be reported to decision makers by establishing a prepaid rent balance. Money has been paid to use the property at a designated time in the future to help generate revenues.

Transaction 10: Payment of Rent in Advance Prepaid Rent (asset) increases $4,000 Cash (asset) decreases by $4,000

Key Takeaway

Accountants cannot record transactions without understanding the financial impact that has occurred. Whether inventory is sold, an account receivable is collected, or some other event takes place, at least two accounts are always affected because all such events have both a cause and an effect. Individual account balances rise or fall depending on the nature of each transaction. The payment of insurance, the collection of a receivable, an owner’s contribution, and the like all cause very specific changes in account balances. One of the most common is the sale of inventory where both an increase in revenue and the removal of the merchandise takes place. Increases and decreases in inventory are often monitored by a perpetual system that reflects all such changes immediately. In a perpetual system, cost of goods sold—the expense that measures the cost of inventory acquired by a company’s customers—is recorded at the time of sale.