Recording Transactions using. Financial Statement Approach
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1 Recording Transactions using Financial Statement Approach Retail Company Example The current presentation will cover the basics of recording transactions using the financial statement approach. We will use Barnes Booksellers as our example. This company is a retail business. It purchases books from publishers and sells them to the public. The significant difference between this retail business and our previous example of Mike s Barbershop will occur in the sale. We will see an important principle of accrual based accounting at work. The principle is called the Matching Principle. It states that we should attempt to match the relevant expenses associated with the generation of revenue. This principle allows us to get a better measure of the gross profits generated by a particular transaction. You might look back at the Overview of Financial Statements Presentation where Proctor & Gambles income statement was shown. There, the first three lines of the income statement demonstrated the gross profits generated by P&G for each year. This is where our discussion of a single sale will lead.
2 1. Barnes purchases a $20 book from a publisher. Barnes pays cash for the book.
3 1. Barnes purchases a $20 book from a publisher. Barnes pays cash for the book. +20 Inventory - 20 Cash The book that Barnes purchases will go into its inventory of books (e.g., be put on the shelf for sale). Notice, the book is not recorded as an expense. The book is something of value that Barnes has it is an asset. We merely transformed one asset (cash) into another (inventory).
4 2. Barnes sells the book purchased in question 1 to a customer for $30. The customer pays cash.
5 2. Barnes sells the book purchased in question 1 to a customer for $30. The customer pays cash. +30 Cash +10 Retained Earnings Inventory Here is the Matching Principle at work. When Barnes purchased the book, it was recorded as an addition to assets (inventory) rather than an expense. Now, Barnes has sold the book and does not have the asset any longer. Thus, we now expense the book and decrease the inventory asset by the same amount. Notice how this allows to get a good measure of the profit made on this transaction. Barnes bought the book for $20 and sold it for $30, thus making a $10 profit. If we had shown an expense when Barnes first bought this book, then as time went on we might have had difficulty determining the profit from this transaction.
6 3. Barnes purchases a $40 book from a publisher on credit (i.e., Barnes asked to be billed for the book and will pay later).
7 3. Barnes purchases a $40 book from a publisher on credit (i.e., Barnes asked to be billed for the book and will pay later). +40 Inventory + 40 Accounts Payable
8 4. Barnes sells the $40 book to a customer for $60. The customer has asked to be billed for the book.
9 4. Barnes sells the $40 book to a customer for $60. The customer has asked to be billed for the book Accounts Receivable + 20 Retained Earnings Inventory This transaction is nearly identical to the previous sale. The only real difference (besides the numbers involved) is that Barnes sold the book to the customer on credit rather than for cash. The customer owes Barnes $60 for the book. This represents an asset for Barnes which we call Accounts Receivable. Finally, notice that the NET change in assets is an increase of $20. This is balanced on the right hand side of the balance sheet (i.e., Liability + Equity) by increase in retained earnings by $20. Thus, the balance sheet balances!
10 5. Barnes receives the $60 the previous customer owes them for the book.
11 5. Barnes receives the $60 the previous customer owes them for the book Cash - 60 Accounts Receivable
12 6. Barnes pays the publisher $40 for the book it had previously purchased on credit.
13 6. Barnes pays the publisher $40 for the book it had previously purchased on credit Cash - 40 Accounts Payable Barnes owed (i.e., had a liability) the publisher $40. It has now made good on that liability and we need to show the liability (accounts payable) decrease by the amount.
14 7. Barnes pays its sales clerk her weekly wages of $300.
15 7. Barnes pays its sales clerk her weekly wages of $ Cash -300 Retained Earnings The wages of its sales force represent an expense for Barnes. On a normal balance sheet this account will be included in the Selling, General & Adminstrative Expenses Account. Thus, similar accounts can be grouped together in order not to clutter the income statement too much. We would not want to list each employee s wages on a final income statement. Rather, we want to show people looking at our company how much this type of expense runs us for a time period (monthly, quarter, annually, etc.). Finally, notice it would not have mattered if we hadn t actually cut a check to the employee. If the employee has earned the wages, then we would want to show them as an expense. If we hadn t actually paid the employee yet, then we would record a liability (e.g., accounts payable) in the amount to balance the expense and decrease in retained earnings.
16 8. Barnes signs an agreement with a local school to supply them with $2,000 worth of books. The school pays Barnes the entire $2,000 today, but the books will not actually be delivered until next week.
17 8. Barnes signs an agreement with a local school to supply them with $2,000 worth of books. The school pays Barnes the entire $2,000 today, but the books will not actually be delivered until next week. + 2,000 Cash +2,000 Unearned Revenue This is kind of an interesting transaction. Barnes received the cash today, but has not actually earned it. They have not actually fulfilled their promise to supply the books to the school. Thus, in a sense, Barnes owes the school $2,000 worth of books. This is why we have increased a liability. It doesn t matter whether they owe money or books, they owe something and have thus incurred a liability. We use the descriptive label of unearned revenue for this type of transaction. What happens next week when they do supply the books?
18 9. Barnes supplies $2,000 worth of books to the local school from question 8. Barnes had the books in inventory. The books had originally cost Barnes $1,500 to purchase from the publisher.
19 9. Barnes supplies $2,000 worth of books to the local school from question 8. Barnes had the books in inventory. The books had originally cost Barnes $1,500 to purchase from the publisher. - 1,500 Inventory - 2,000 Unearned Revenue Retained Earnings 2,000 1, First, does the balance sheet actually balance? YES!!! Assets have decreased by $1,500 while the sum of liabilities and equity has decreased by a total of $1,500 as well. What has happened? Barnes has fulfilled it obligation to supply $2,000 worth of books. Thus, we have decreased its liability by that amount. By fulfilling its obligation, it has now earned the $2,000. We recognize that revenue has been earned. The $1,500 in books that Barnes had in inventory is gone. Thus, we decrease the asset by that amount and show the expense. Barnes made $500 in profit (net income) from the transaction which increases its retained earnings (equity) by the same amount.
20 10. The business has been doing so well that Barnes plans to expand by opening up two new stores. First, however, they will need to raise the money to finance the eventual expansion. They decide to sell 1,000 shares in the company (the shares represent part ownership in the business) at a price of $20 per share.
21 10. The business has been doing so well that Barnes plans to expand by opening up two new stores. First, however, they will need to raise the money to finance the eventual expansion. They decide to sell 1,000 shares in the company (the shares represent part ownership in the business) at a price of $20 per share. +20,000 Cash +20,000 Capital Stock Barnes has been able to raise $20,000 in cash. Thus, assets have increased by that amount. The sale of shares represents an investment into the business by the people who buy the shares. Thus, it increases the new worth (or, equity) of the business. The people buying the shares will show a decrease in cash (asset) and an increase in stock (asset) on their own balance sheet. We have used a generic account name of Capital Stock to keep track of the investment into Barnes. As we will see later, various names are used for the sale of shares by a corporation (e.g., paid-in capital, etc.). You should note that it is only with the initial sale of shares (or, stock) that a corporation raises money and changes their balance sheet. If the people that bought these particular shares decide to sell them to someone else (e.g., on the New York Stock Exchange), it will not impact Barnes s financial statements. We might briefly compare this sort of financing with Mike of Mike s Barbershop getting a bank loan. He raised money as well. But, the bank loan represented a liability. Here, in Barnes case, they are taking on new ownership partners in a way.
22 11. Barnes decides to pay a dividend to its shareholders. It pays 50 cents per share to each of the 1,000 shares.
23 11. Barnes decides to pay a dividend to its shareholders. It pays 50 cents per share to each of the 1,000 shares Cash -500 Retained Earnings Notice the payment to owners (i.e., shareholders) does NOT represent an expense for Barnes. You can think of the payment of dividends as coming out of profit (or, net income) or accumulated profits. Thus, we need to calculate profit (net income) prior to subtracting dividends. Again, we see this in the basic relationship between the income statement and balance sheet. Ending Retained Earnings = Beginning Retained Earnings + Net Income Dividends The net income in the relation above is determined from the income statement. It is only after this that we subtract the dividend payments and decrease the ending retained earnings.
24 12. Barnes sells $200 worth of books to a customer for cash. The books had cost Barnes $140 to purchase from the publisher.
25 12. Barnes sells $200 worth of books to a customer for cash. The books had cost Barnes $140 to purchase from the publisher Cash +60 Retained Earnings Inventory This question was just to emphasize the recording of a sale for a retailer.
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