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Identify the Impact of Common Transactions (9m:57s)

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Slides 1-2 (:24s)Welcome to Introduction to Accounting Preparing for a User’s perspective. Identify the impact of common transactions on a new company’s financial statements.

In this learning outcome we’re going to track the life of a simple start-up business run by my son Spencer. He will start with nothing, and then enter into several transactions as he strives to use his management skill to take his business idea from just an idea, Utah Straw Hat Company (HSHC), into a profitable entity.

Slide 3 (:36s)
But where can he get the money he needs to get started. He needs some assets. He could break open his piggy bank take the cash and coins out of the piggy bank and contribute them to Utah Straw Hat Company and thereby be an owner. He could also go to his dad and his dad could act as a lender providing loans to Utah Straw Hat Company, or as an investor where dad would become a partner or an equity investor in the business.

Spencer could also go to the local bank and ask for a loan. At any rate, Spencer’s Utah Straw Hat Company will need some assets and those assets will need to be funded through either debt or equity.

Slide 4 (:30s)
That brings up the balance sheet equation.

As you know, what a company has should also be equal to the claims against what it has. What it has are known as assets. Then, on the other side of the equation, we need to describe how they finance those assets. Another way of saying that is, “Who has claim on those assets?” The answer to that question is that lenders and creditors which are summarized on the balance sheet as liabilities, also known as borrowings, and equity, these are the owners’ claims against those assets.

Slide 5 (:37s)Day 1. Let’s dig into Spencer’s new business starting on day one. The original owner, Spencer, invests in the business. On January 1 X6, Spencer invested $51 of his own piggy bank money into Utah Straw Hat Company thereby obtaining 100% ownership of the new company.

Let’s look at what that does to the balance sheet equation. USHC’s assets will increase $51 representing the cash that it just received. Liabilities have not changed because Spencer did not loan the money to the company but rather he invested and became an owner. So assets increase by $51 and his equity in those assets increase by $51.

Slide 6 (:37s)Day 2. Let’s go on to day 2. Partner invests. On January 2^nd X6 dad becomes a partner and invests $49 thus receiving 49% ownership. Spencer’s ownership now only claims 51% of USHC’s assets. Our prior balance sheet showed $51 in assets and Spencer’s equity in those assets. Now with dad’s contribution of $49 total assets are now $100. Who has claim to those assets? Liabilities didn’t change, but dad now has equity of $49 claimed against those assets and therefore we balance again.

Slide 7 (:45s)Day 3. Spencer realizes he needs some more money say he goes and obtains a bank loan. On January 3 X6, USHC borrowed $200 from St. George International Bank for one year at 12% simple interest to be paid annually.

The previous balance sheet showed assets of $100 and all of it being claimed by the equity partners. USHC borrowed $200 thus increasing assets, these are cash assets in this case, resulting in $300 in assets at the end of the period. Liabilities increased $200 because this increase of $200 [in assets] is fully claimed by the bank because they provided that financing. Liabilities are now $200 and equity didn’t change at all but as you can see, assets of $300 equal total liabilities of $200 and equity of $100 totaling $300.

Slide 8 (:42s)
Day 4. The Company orders inventory. On January 4^th X6 USHC creates and sends a purchase order to China Hat Company its vendor to purchase 100 hats at $.50 per hat. So that’s going to be $50 of hat purchases. The previous balance sheet showed $300 in assets claimed by the lenders and by the owners. At this point, since this was just an order there’s no current impact on the financials. We don’t owe any money for these hats because we haven’t purchased them yet. But it will be recorded in the accounting system, such as QuickBooks, to remember the purchase, document its authorization and receive the goods. This is called a purchase order. It’s not actually an accounting transaction yet.

Slide 9 (:45s)Day 5. Now on day 5 we actually receive the inventory. CHC delivers 100 hats. Total invoice amount is $60 as follows: $50 for the hat cost itself which was 100 hats at $.50 each, $7 for shipping and $3 for sales tax.

Assets will go up by $60 because that is the total cost of this new inventory and we’re at $360 in assets. Now who has claims against those assets? $60 is owed for the total invoice that is the amount owed. We now owe $260 in liabilities. Equity did not change because this, under what we call accrual accounting, is not yet an expense. We have the asset of inventory and we owe the vendor for that inventory. It is not an expense yet because we still have the asset and it still has value.

Slide 10 (1m:10s) Day 6. Now when we sell the inventory it changes things a little bit. On day 6 the company sells inventory to a customer. USHC sold 10 hats, on account, that means the customer is going to pay later, to a Ali’i Turf company for $21 ($20 is the sales price, one dollar is the sales tax on that sales price). This sales tax we will have to submit to the state government. The 10 hats cost $6, so this is the sales price, but what did it cost Spencer? $6.

We started with the prior balance sheet, and then we added $21 representing the sales price and the sales tax, that’s a receivable from the customer, that’s an asset and we owe a dollar to the state for state sales tax payable, and the other $20 increases the owners’ equity. That’s revenue, that’s going to be on the income statement which increases the owners’ revenue and equity, and we gave up $6 of inventory, that comes out of our assets. Since we gave up inventory in making a sale we’re going to have an expense called cost of goods sold which will appear on the income statement. Effectively our margin on this sale was $14 and that margin belongs to the owners. Total assets $375 total liabilities $261 and the difference is $114 belonging to the owners.

Slide 11 (:29s)Day 7. USHC writes a check (number one) to pay off the $60 invoice from China Hat Company. We start with our prior balance sheet, then we give away $60 in cash, reducing our assets to $315 and our liabilities go down by $60. Why did we give up this $60 in assets? It was to pay off this liability that was in there. We are down to liabilities of $201. The difference is still equity of $114.

As you notice the equity did not change from Day 6 because all we did was we reduced assets and liabilities by the same amount of $60, equity is not impacted.

Slides 12-13 (:53s)Day 8. The company receives the customer payment from Ali’i Turf in the amount of $21. We start with the balance sheet numbers from the prior day then we received $21 in cash in exchange for the receivable. So in other words in this $315 Ali’i Turf owed us $21. They paid the $21 in cash and therefore we forgive them the receivable. Total assets did not change and remain at $315. In addition since total assets didn’t change liabilities and equity also don’t change.

At this point the company can prepare a draft of its unadjusted financial statements. We call it unadjusted because we haven’t really accounted for some things like interest expenses that we might record at the end of the month to provide a more perfect representation of the cost of doing business, but at least right now we can kind of see where we’re at using draft unadjusted financial statements.

Slide 14 (:45s)
Income Statement. With that in mind let’s look at them. Here is the draft income statement.

As you can see you take the sales revenue less the cost of goods sold to get what’s called the gross margin. If you’ve ever seen the Shark Tank (an American reality show in which potential entrepreneurs present their business ideas and request funding from investors) they focus a lot on the percentage of gross margin. So if you take the gross margin divided by the sales revenue you arrive at 70% that is a pretty good margin percentage because it’s this margin that can pay for the other operating expenses of running the business. If this gross margin is too small in percentage terms or in dollar terms to cover the operating expenses you are going to result in a net loss for the business.

In this case we haven’t accounted for rent and utilities, so these will come in still and hopefully they will be less than the gross margin produced by making the sales. So far, at least in the unadjusted draft financials, it looks like Utah Straw Hat Company is profitable.

Slide 15 (:21s)Statement of Partners’ Equity.

LO5-2bUSHCStmtOfPartner'sEquity.png

As you can see we keep track of the 2 partners' equity accounts separately. Spencer’s equity began with his original contribution of $51 and then he obtained 51% of the $14 in net income. Dad got 49% of that income so this is their new breakout of their equity in this $114.

Slide 16 (:40s)Balance Sheet. The balance sheet.

Utah Straw Hat Company is sitting with $261 in cash and it has $54 of inventory sitting around in its warehouse. As we know it has a 70% margin, so if we could sell this inventory, the value of this sold is a lot more than the value of this sitting on the shelf so the goal will be to get this sold hopefully at the same 70% margin. We still owe the state for sales taxes. We still owe the bank for notes payable. We haven’t yet computed the interest owed but we will as we finish this at the end of January. So January 31^st we will prepare final financials that will include the interest payable. Finally, we see the owners’ capital.

As you can see total assets of $315 equals total liabilities and owners’ equity of $315.

Slides 17-18 (:53s)Statement of Cash Flows. Finally we have a Statement of Cash Flows.

Now this is interesting. Actual cash received from customers was $21 but we’ve already paid are suppliers $60 so although on the income statement we showed positive net income of $14 the actual cash flows from operating activities are -$39. Luckily we had borrowed some money from the bank and we also had partners who contributed, so we haven’t gone into a negative cash position yet, but as we sell more goods hopefully we will generate positive cash flow from operating activities and move into a profitable position from a cash perspective.

What we have just done is simply go through a bunch of transactions for a new business and show the resulting impact on the balance sheet equation and the financial statements I hope this has helped you kind of get a perspective of the flow of accounting for transactions and the resulting financial statements.