Cash declined by $700 as a result of the payment.The Effects Caused by Common Transactions
Question: Transaction 4—The inventory items that were bought in Transaction 1 for $2,000 are now sold for $5,000 on account. What balances are impacted by the sale of merchandise in this manner?
Answer: Two things actually happen in the sale of inventory. First, revenue of $5,000 is generated by the sale. Because the money will not be collected until a later date, accounts receivable (an asset) is initially increased. The reporting of receivable balance indicates that this amount is due from a customer and should be collected at some subsequent point in time.
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 system will be utilized. That approach has become 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 companies—known as a periodic inventory system will also be demonstrated.
Since a perpetual system is being used here, the reduction in inventory is recorded simultaneously with the sale. An expense is incurred as inventory costing $2,000 is taken away by the customer. The company’s assets are reduced by this amount. Cost of goods sold (an expense) is recognized to reflect this decrease in the amount of merchandise on hand.
cost of goods sold (expense) increases by $2,000
inventory (asset) decreases by $2,000
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.
Question: In each event that has been 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, accounts receivable increases because of a sale. Cash decreases as a result of paying salary expense. No account 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.
Question: Transaction 5—The reporting company pays $700 for insurance coverage relating to the past few months. The amount was previously recorded in the company’s accounting system as the cost was incurred. Apparently, computers were programmed to accrue this expense periodically. What is the financial impact of paying for an expense if the balance has already been recognized over time as the liability grew larger?
Answer: Several pieces of information should be noted here as part of the analysis.
Cash declined by $700 as a result of the payment.
This cost relates to a past benefit; thus, an expense has to be recorded. No future economic benefit is created by the insurance payment in this example. Cash was paid for coverage over the previous months.
The company’s accounting system has already recorded an accrual of this amount. Thus, insurance expense and the related liability were recognized as incurred. This is clearly a different mechanical procedure than that demonstrated in Transaction 2 above for the salary payment.
The expense cannot be recorded again or it will be double-counted. Instead, cash is reduced along with the liability 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.
insurance payable (liability) decreases by $700
cash (asset) decreases by $700
Note that accounting recognition is often dependent on the recording that has taken place. The final results should be the same (here an expense is recognized and cash decreased), but the steps in the process can vary.
Question: Transaction 6—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 to be a bit more complicated because more than two figures are involved. What is the financial impact of buying an asset when only a portion of the cash 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 recorded balance 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.
truck (asset) increases by $40,000
cash (asset) decreases by $10,000
notes payable (liability) increases by $30,000