Effects of Transactions on Accounting Reports

Overview

This section covers how business transactions affect the core accounting reports: the Balance Sheet and the Profit and Loss Statement (Income Statement). Understanding these effects is crucial for analyzing a business’s financial performance and position.

1. The Accounting Equation

The foundation of understanding transaction effects is the Accounting Equation:

$$Assets = Liabilities + Owner’s Equity$$

Every transaction affects at least two accounts within this equation to keep it balanced.

KEY TAKEAWAY: The Accounting Equation must always remain balanced.

1.1 Assets

• Definition: Resources controlled by the business as a result of past events and from which future economic benefits are expected to flow to the business.
• Examples: Cash, Accounts Receivable, Inventory, Equipment, Buildings.
• An increase in an asset is recorded as a debit; a decrease is recorded as a credit.

1.2 Liabilities

• Definition: Present obligations of the business arising from past events, the settlement of which is expected to result in an outflow from the business of resources embodying economic benefits.
• Examples: Accounts Payable, Loans Payable, Unearned Revenue.
• An increase in a liability is recorded as a credit; a decrease is recorded as a debit.

1.3 Owner’s Equity

• Definition: The residual interest in the assets of the business after deducting all its liabilities. Represents the owner’s claim on the business’s assets.
• Components:
  • Capital: The owner’s initial investment and subsequent contributions.
  • Drawings: Withdrawals of cash or other assets by the owner for personal use.
  • Revenues: Increases in owner’s equity resulting from the normal business operations.
  • Expenses: Decreases in owner’s equity resulting from the normal business operations.
• Increases in capital and revenues are recorded as credits; increases in drawings and expenses are recorded as debits.

REMEMBER: “DEAD CLIC” – Debit Expenses, Assets, Drawings; Credit Liabilities, Income (Revenues), Capital.

2. The Balance Sheet

The Balance Sheet is a “snapshot” of a business’s assets, liabilities, and owner’s equity at a specific point in time. It reflects the accounting equation.

2.1 Effects of Transactions on the Balance Sheet

Transactions can affect the Balance Sheet in several ways:

• Increase one asset, decrease another asset: E.g., purchasing inventory with cash.
• Increase an asset, increase a liability: E.g., purchasing inventory on credit (Accounts Payable).
• Decrease an asset, decrease a liability: E.g., paying off Accounts Payable with cash.
• Increase an asset, increase owner’s equity: E.g., owner invests cash into the business.
• Decrease an asset, decrease owner’s equity: E.g., owner withdraws cash for personal use (Drawings).

2.2 Example

EXAM TIP: When analyzing the effect of a transaction on the Balance Sheet, always identify the two accounts affected and whether they increase or decrease.

3. The Profit and Loss Statement (Income Statement)

The Profit and Loss Statement summarizes a business’s revenues and expenses over a period of time to determine its net profit or net loss.

$$Net \ Profit \ (or \ Loss) = Total \ Revenues - Total \ Expenses$$

3.1 Effects of Transactions on the Profit and Loss Statement

• Revenues: Increase owner’s equity (and ultimately retained earnings). Generally result in an increase in assets (e.g., cash or accounts receivable).
• Expenses: Decrease owner’s equity (and ultimately retained earnings). Generally result in a decrease in assets (e.g., cash) or an increase in liabilities (e.g., accounts payable).

3.2 Example

COMMON MISTAKE: Confusing the timing of cash flow with revenue/expense recognition. The P&L statement follows the accrual accounting principle, not cash accounting.

4. The Relationship Between the Balance Sheet and Profit and Loss Statement

The Profit and Loss Statement “feeds” into the Balance Sheet through the Retained Earnings account within Owner’s Equity.

• Net Profit increases Retained Earnings.
• Net Loss decreases Retained Earnings.
• Drawings also decrease Retained Earnings.

Thus, the P&L Statement explains the change in Owner’s Equity (specifically retained earnings) between two Balance Sheet dates.

APPLICATION: Investors and creditors use both the Balance Sheet and the Profit and Loss Statement to assess a business’s financial health and performance.

5. GST (Goods and Services Tax)

GST is a 10% tax on most goods, services and other items sold or consumed in Australia.

5.1 GST on Sales

When a business makes a sale it is required to collect GST on behalf of the Australian Taxation Office (ATO). This is known as GST Collected. GST Collected is a liability because the business owes this money to the ATO.

5.2 GST on Purchases

When a business makes a purchase it is required to pay GST. This is known as GST Paid. GST Paid is an asset because the business will be reimbursed this money by the ATO.

5.3 GST Clearing Account

The GST Clearing account is used to reconcile the GST Collected and GST Paid amounts.

• If GST Collected > GST Paid, the business owes the ATO. GST Clearing has a credit balance (liability).
• If GST Collected < GST Paid, the ATO owes the business. GST Clearing has a debit balance (asset).

5.4 Effects of GST on Reports

• Balance Sheet: The GST Clearing balance (either debit or credit) is reported as an asset or liability.
• Profit and Loss Statement: Sales revenue and expenses are reported exclusive of GST. GST itself is not an expense or revenue.

VCAA FOCUS: VCAA exams frequently test your understanding of how GST affects transactions and the accounting equation. Pay close attention to the debit and credit entries for GST Collected and GST Paid.