Accounting Transactions and

Equation
Chapter 2

Dr Abrham E.
Financial and Managerial Accounting

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consent of McGraw-Hill Education.
 Accounting Equation

• In any organization, you will find properties such as a

building, furniture, land, vehicles and the like. Such
properties owned by business enterprises are
referred to as Assets.
• To buy these assets, businesses get money from two
sources: investments made by owners or amounts
borrowed from creditors.
• Therefore, both owners and creditors have a claim
over the assets of the business enterprise, which is
called Equities.
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• The relationship between the two may be stated in the form
of an equation, as follows:
• Economic Resources = claims over the resources
ASSET = EQUITY

• If the assets owned by a business amount to Birr 50,000 the

equities in the assets must also amount to Birr 50,000.

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• Equity may be subdivided in to two principal types: the rights
of creditors and the rights of owners. The rights of creditors
represent debts of the business and are called Liabilities. The
rights of owners are called Owners’ Equity (capital).
Assets=equities
Equities = Liability + Owner’s equity

• This equation can be written as:

Assets= liability + Owner’s Equity

It is customary to place “liabilities“ before “Owners equity” in the accounting equation because
creditors have priority (preferential) rights to the assets. Because of this, the owners have a
residual claim over the assets

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 Asset Accounts

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Learning Objective C2: Describe an account and its use in recording transactions.
 Liability Accounts

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Learning Objective C2: Describe an account and its use in recording transactions.
 Equity Accounts

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Learning Objective C2: Describe an account and its use in recording transactions.
 Expanded Accounting Equation
Revenues and common stock increases equity.
Expenses and dividends decrease equity.

Exhibit 2.2
Accounts Classified by the Expanded Accounting Equation
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Learning Objective C2: Describe an account and its use in recording transactions.
 Accounting transactions and the concept of double entry

What is accounting transaction?

• Business transactions are economic events that should be
recorded because they affect the financial position of the
business enterprise.
• All business transactions from the simplest to the complex can
be stated in terms of the resulting effect on the three basic
elements of the accounting equation.
• How ever, it is important to remember that each transaction
leaves the equation in balance. Assets always equal the sum
of liabilities and owner’s equity

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• For a given transaction to qualify to be recorded it has:
– to be related to the business enterprise
– to be measurable in terms of money
– to be completed / happened/ action.(i.e. it should not be a mere promise
or intention; it must be at least partially completed to be recorded)

• Accounting transactions are recorded based on double –entry

accounting system

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What is double-entry accounting?
• In a double-entry accounting system, transactions are composed of debits
and credits. The debits and credits must be equal in order for the system
to remain balanced.
• Debit Credit
• -Increase in assets -Decrease in assets
• -Increase in expenses -Decrease in
expenses
• -Decrease in capital -Increase in capital
• -Decrease in liabilities -Increase in liabilities
• -Decrease in revenue -Increase in revenue

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 Double-Entry Accounting

Assets = Liabilities + Equity

Exhibit 2.6

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Learning Objective C4: Define debits and credits and explain double-entry accounting.
 Process of recording accounting transactions

Business transactions and events are the starting points of

financial statements.
Process from transactions to financial statements is as follows:
• Identify each transaction and event from source documents.
• Analyze each transaction and event using the accounting
equation.
• Record relevant transactions and events in a journal.
.

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Learning Objective C1: Explain the steps in processing transactions and the role of source documents.
 Source Documents
Source documents identify and describe transactions
entering the accounting system.
Examples:
• Bills from suppliers.
• Sales receipts.
• Checks.
• Purchase orders.
• Payroll records.
• Bank statements.

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Learning Objective C1: Explain the steps in processing transactions and the role of source documents.
 Illustration
• Transactions of ABC company for year 20xx ,
1. Received cash of 30,000 Br as investment by the owner
2. Purchase supplies of 2500 Br in cash
3. Purchase of equipment of 26000 Br in cash
4. Purchase of supplies of 7100 Br on credit
5. Provide service for 4200 Br received in cash
6. Payment of rent expense of 1000 Br in cash
7. Payment of salary expense of 700 Br in cash
8. Provide services ( rental service for 300 Br and consulting service for 1600 Br ) on
credit
9. Received cash of 1900 Br for transaction number 8
10. Partial payment of 900 Br in cash for the transaction #4

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11. Payment of cash of 200 Br as a dividend for investors
12. Received of cash amounted 3000 Br for future service
13. Pay cash of 2400 Br for future insurance coverage
14. Purchase supplies of 120 Br in cash
15. Payment of utility expense of 305 Br in cash
16. Payment of salary expense of 700 Br in cash

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 Class work
Nov 1. Received Br 56,000 from the owner as an investment.
1. Rented office space and paid cash for the month’s rent of 800
3. Purchased electrical equipment for 14,000 by paying 3,200 and agreeing to pay the
remaining balance in six months
5. Purchased office supplies by paying 900 cash.
6. Completed electrical work and received 1,000 cash for doing the work.
9. Purchased 3,800 of office equipment on credit
15. Completed electrical work on credit in the amount of 4,000
20. Paid for the office equipment purchased on Nov.9
24. Billed a customer for electrical work completed 600
28. Received 4,000 for the work completed on Nov.15
30. Paid salary of employees 1,200
30. Paid the monthly utilities bill 440
30. Withdrew 700 from the business for personal use

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Accounting life cycle

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• Accounting Cycle: It refers to a complete sequence of
accounting procedures, which are required to be repeated in
the same order during each accounting period.
• It is complete sequence beginning with the recording of the
transaction and ending with the preparation of the final
accounts.

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 Procedure in ALC
1. Analyze the transaction
2. Journalize the transaction
3. Post the transaction to accounts in ledger
4. Prepare the trial balance
5. Prepare financial statements
6. Prepare final accounts

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 Recording transactions on general
journal
When a business transaction • The process of recording
takes place, source documents
will be obtained and recorded. a business transaction in
 The accounting record in the accounting record is
which a transaction is initially called journalizing.
recorded is known as a journal.
The journal is therefore referred
to as “The book of original entry”

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Learning Objective C2: Describe an account and its use in recording transactions.
 Steps in Journalizing a Transaction

The following steps should be followed in recording a transaction in the journal.

• Record the date - Insert the year, the month, and the date.
• Record the Debit- Insert the account debited in the description column and the
amount of debit in the debit column.
• Record the credit- Insert the account credited below the debited account and
indented to the right in the description column and the amount of credit in the
credit column.
• Explanation- Write a brief explanation or reference to source document in the
description column, when necessary.

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 Journalizing Transactions
Exhibit 2.10

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Learning Objective P1: Record transactions in a journal and post entries to a ledger.
Posting transactions on to ledger accounts.

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 Posting…
After the information about a business transaction has been journalized, that
information is transferred to the specific accounts affected by each
transaction.
This process of transferring the information is called posting.

The ledger is a collection of all accounts and their balances for an

accounting system.
Exhibit 2.4

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Learning Objective C3: Describe a ledger and a chart of accounts.
 Journalizing and Posting
Transactions
Exhibit 2.9

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Learning Objective P1: Record transactions in a journal and post entries to a ledger.
 Debits and Credits
A T-account represents a ledger account and is
used to show the effects of one or more
transactions.
Exhibit 2.5

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Learning Objective C4: Define debits and credits and explain double-entry accounting.
 Processing Transactions #1
Let’s look at the previous example

1. Receive Investment by Owner

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #2
2. Purchase Supplies for Cash

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #3
3. Purchase Equipment for Cash

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #4
4. Purchase Supplies on Credit

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #5
5. Provide Services for Cash

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #6
6. Payment of Expense in Cash

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #7
7. Payment of Expense in Cash

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #8
8. Provide Consulting and Rental Services on Credit

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #9
9. Receipt of Cash on Account

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #10
10. Partial Payment of Account Payable

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #11
11. Payment of Cash Dividend

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #12
12. Receipt of Cash for Future Services

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #13
13. Pay Cash for Future Insurance Coverage

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #14
14. Purchase Supplies for Cash

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #15
15. Payment of Expense in Cash

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Processing Transactions #16
16. Payment of Expense in Cash

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
 Summarizing Transactions in a Ledger
Exhibit 2.13

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Learning Objective A1: Analyze the impact of transactions on accounts and financial statements.
Prepare a trial balance.

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 Preparing a Trial Balance
Preparing a trial balance has three steps:
1. List each account title and its balance amount (from ledger)
in the trial balance. If an account has a zero balance, list it
with a zero in the normal balance column (or omit it entirely).
2. Compute the total of debit balances and the total of credit
balances.
3. Verify (prove) total debit balances equal total credit balances.

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Learning Objective P2: Prepare and explain the use of a trial balance.
 FastForward’s Trial Balance
The trial balance lists
all ledger accounts
and their balances at
a point in time. If the
books are in balance,
the total debits will
equal the total
credits.

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Learning Objective P2: Prepare and explain the use of a trial balance.
 Searching for Errors
If the trial balance does not balance, the error(s) must be found and
corrected.
1. Make sure the trial balance columns are correctly added.
2. Make sure account balances are correctly entered from the
ledger.
3. See if debit or credit accounts are mistakenly placed on the trial
balance.
4. Recompute each account balance in the ledger.
5. Verify that each journal entry is posted correctly.
6. Verify that each original journal entry has equal debits and
credits.

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Learning Objective P2: Prepare and explain the use of a trial balance.
Prepare financial statements from
business transactions

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 Financial Statements
The four financial statements and their purposes are:
1. Income statement—reports revenues less expenses incurred by a
business over a period of time.
2. Statement of retained earnings—reports changes in retained earnings
over the reporting period from net income (or loss) and from any
dividends over a period of time.
3. Balance sheet—reports the financial position (types and amounts of
assets, liabilities, and equity) at a point in time.
4. Statement of cash flows—lists the cash inflows and cash outflows for the
period.
**For simplicity, we do not show the statement of cash flows for FastForward in this
chapter**

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Learning Objective P3: Prepare financial statements from business transactions.
 Financial Statements Prepared
from Trial Balance
Exhibit 2.15

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Learning Objective P3: Prepare financial statements from business transactions.
 Income Statement
Exhibit 2.16

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Learning Objective P3: Prepare financial statements from business transactions.
 Statement of Retained Earnings
Exhibit 2.16

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Learning Objective P3: Prepare financial statements from business transactions.
 Balance Sheet
Exhibit 2.16

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Learning Objective P3: Prepare financial statements from business transactions.
Individual assignment I
1. Prepare journal entries for the transactions
2. Post the transactions on to general ledger
3. Prepare a trial balance
4. Prepare financial statements

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 Transactions of ABC enterprise for the month November, 2021

Nov 1. Received Br 56,000 from the owner as an investment.

1. Rented office space and paid cash for the month’s rent of 800
3. Purchased electrical equipment for 14,000 by paying 3,200 and agreeing to pay the
remaining balance in six months
5. Purchased office supplies by paying 900 cash.
6. Completed electrical work and received 1,000 cash for doing the work.
9. Purchased 3,800 of office equipment on credit
15. Completed electrical work on credit in the amount of 4,000
20. Paid for the office equipment purchased on Nov.9
24. Billed a customer for electrical work completed 600
28. Received 4,000 for the work completed on Nov.15
30. Paid salary of employees 1,200
30. Paid the monthly utilities bill 440
30. Withdrew 700 from the business for personal use

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 Presentation Issues
1. Dollar signs are not used in journals and ledgers.
2. Dollar signs appear in financial statements and other
reports such as trial balances. Put dollar signs beside
only the first and last numbers in a column.
3. When amounts are entered in the journal, ledger, or trial
balance, commas are optional to indicate thousands,
millions, and so forth.
4. Commas are always used in financial statements.
5. Companies commonly round amounts in reports to the
nearest dollar, or even to a higher level.

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Learning Objective P3: Prepare financial statements from business transactions.
 Learning Objective A2

Compute the debt ratio and

describe its use in analyzing
financial condition.

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 Debt Ratio—Equation

Total Liabilities
Debt Ratio =
Total Assets

Evaluates the level of debt risk.

A higher ratio indicates that there is a greater probability that a
company will not be able to pay its debt in the future.

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Learning Objective A2: Compute the debt ratio and describe its use in analyzing financial condition.
 Debt Ratio—Computation

Total Liabilities
Debt Ratio =
Total Assets

Exhibit 2.18

Company ($ millions) Current Year 1 Year Ago 2 Years Ago

Costco Total liabilities $25,268 $20,831 $22,174
Total assets $36,347 $33,163 $33,017
Debt ratio 0.70 0.63 0.67
Walmart Debt ratio 0.59 0.58 0.58

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Learning Objective A2: Compute the debt ratio and describe its use in analyzing financial condition.
End of unit 2

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