Recording Externally Prompted Transactions

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Accounting for Decision Making

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University of Michigan

Accounting for Decision Making

45 classificações

Through this course, you will start by addressing the two “big questions” of accounting: “What do I have?” and “How did I do over time?” You will see how the two key financial statements – the balance sheet and the income statement - are designed to answer these questions and then move on to consider how individual transactions aggregate to make up these financial statements. After developing a broad understanding of accounting and financial statements, you will begin to develop a more nuanced understanding of individual components of doing business, such as making a sale or building inventory. By considering many of the more common actions of a company, you will build your understanding of accounting, and explore these concepts by applying them across various types of transactions. Once you understand these individual concepts better, you will be ready to return to the overall financial statements and use them as informational tools, including building ratios. You can do this course standalone or to qualify for the residential component of the Finance for Strategic Decision-Making Executive Education program. For more information, see the FAQ below.

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The Accounting Cycle and Bookkeeping: Foundational Tools for a Deeper Understanding

In this module we will create a set of accrual accounting financial statements. We will use that experience to walk you through the accounting cycle - which is the process by which accounting captures and aggregates all of the transactions in the period into a set of financial statements. We will examine each step in the accounting cycle using a comprehensive example of a start up wholesale book retailer. You will learn how the steps combine to create the statements. In addition to the comprehensive example we will do together, there will be plenty of chances to practice each step yourself. This module ends with a chance for you to build your own set of financial statements for a start up company. Fair warning: in my opinion this is the least exciting material covered in any accounting class (including this one). It is the basic bookkeeping process, not the interesting part of building an understanding of the business. But just as you need to learn basic addition and subtraction before you can master the math to design a beautiful building, you also need to learn basic bookkeeping as a foundation for the more interesting accounting.

Recording Externally Prompted Transactions23:29

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Greg Miller
Professor
Ross School of Business

Welcome.

In this video, I'm going to use our comprehensive example to show you how we

record externally prompted transactions.

Now, I'm going to warn you upfront.

And in fact, I'm going to apologize to you upfront.

This video is going to be long and it's not going to be the most exciting one that

we do, but it is important to know it.

And if it makes you feel better, you can speed me up and slow me down and

kind of make it do funny things as we go along.

Well, let's not drag this out any further.

Let's just go ahead and get started.

So, remember our transaction one?

Our shareholders contributed $100,000 in exchange for their common stock.

I'm going to apply that three step process that we call the accounting process.

I'm going to analyze it.

I'm going to journalize it and then I'm going to post it to the account, and

show you how to do all that.

I'm going to do that for each of these eight transactions, but let's go ahead and

start with number one.

So, let's analyze it.

How does our company change?

Well, we now have $100,000 in cash.

That something that we didn't have before and

we have given some other people the rights to be owners.

That means that they have the right to future potential cash flow,

maybe some voting rights, etc.

We have a whole video on what that really means.

But from an analyzing standpoint,

we want to reflect the fact that we have cash now and we also have owners.

Another way to think of it is we have cash and

it came from owners directly value into the firm.

So now that we have analyzed it, it's time to journalize it.

I think I have told you before,

I always like to start with a cash part of a journal entry.

So, let's do that first.

Our cash has gone up $100,000.

Cash is an asset.

So, that means it's a debit.

So, the first thing we'll do is we'll debit cash for $100,000.

Now I put asset in brackets there for you just as a reminder,

I'll do that throughout this video.

You don't really have to do that in a journal entry.

I just think it's helpful for what we're trying to do right now.

So, we've got half the journal entry done.

Cash has gone up by $100,000 and we debited it, because of that.

What's the other half?

Well, we have something that came from our shareholders.

I'm going to call it common stock paid in capital here.

Other people might call it additional paid in capital or

capital from common stockholders.

You're going to see different titles for accounts.

It's not important that people use slightly different words.

It's important that economically, you understand what it means.

Whatever you would have called this,

we credit it to show that this equity account has gone up by $100,000.

Now if this was a real journal, we'd even write just a little bit of verbiage

about what this was really capturing.

So, this is to record the initial equity investment in the company.

I want you to notice a couple of other things.

Notice that number one, by the cash.

That means this is the first journal entry in this company and

will always be able to go back to that journal entry using that one,

if we need to understand what's occurred here.

I also want you to notice that our debits and credits equal.

Remember, we need our debits and credits to always equal in every transaction.

We have a $100,000 in debits and a $100,000 in credits.

We're all done journalizing now.

We've checked ourselves.

It balances.

It seems to match our analysis.

Let's put it in T accounts.

We're going to need a cash T account and a paid in capital T account.

Now, we debited our cash account in the journal entry.

So, what side do we out that on the T account?

Recall, when we're using T accounts,

debits always go on the left as you're looking at the screen.

So, we'd put our $100,000 in here.

Noticed we put that little number one by it,

so we can keep track of why we got that $100,000.

Our paid in capital account, we credited that in the journal entry and

credit is always going on the right as we're facing the screen.

So now, we've entered both of those in to our T accounts.

We're ready to move on to the next transaction.

For the next transaction, the company signed a lease for its warehouse and

offices.

They paid $24,000 in advance and that lease gives them the use of this for

six months.

The first thing we have to do is analyze.

Well, again, I like to start with the cash part.

One thing we know for sure is we have 24,000 less of cash.

That's gone out of the company.

Well, where did that go?

Well, we got this right to use the warehouse in the future.

We're going to use that warehouse and offices as a way to sell these books.

So, we've got something that we're going to use to create future benefit.

Does that start to feel like our definition of an asset?

It does to me.

In fact, let's test whether we think we've got an asset here.

The asset has three criteria.

Probable future economic benefit.

Here, we're going to use it to sell books.

So, it seems like we meet that criteria.

Under our control, yes, for six months, nobody else can use this space.

It's just for us.

From a past transaction, yeah, we gave them $24,000.

They gave us the keys to the space.

So, it appears that we got some sort of an asset for that $24,000.

Now that we know that it's an asset, we know we're going to debit it.

Let's move to the journal entry.

It feels like we've analyzed fairly well.

Again, I'm going to start with the cash part.

In this case, our cash has gone down.

An asset going down is credited.

So we'll go ahead and credit the cash account by $24,000,

then we've got this other new asset.

I'm going to call it prepaid rent.

Now if you did this journal entry,

you could have called it a lease if you wanted to.

Some people might just call it property, plant and equipment.

Although I'd like to make it clear that it's related to something

that we're renting instead.

But again, there's no right answer.

More there's answers that help us to understand.

Remember, the whole goal of the financial statements is to help decision makers make

decisions.

If a word like prepaid rent helps them understand the company, so

they can make a better decision, then that's a good word for it.

Again, notice that just like our last journal entries, our debits and

credits is equal.

One thing that is different here, though is assets in both cases.

So what we've done is taken one asset, cash and

turned it into another asset, prepaid rent.

And we could record that with some verbiage, as well.

This is to reflect the short term lease of space, which has been prepaid for

six months.

I'm not going to keep giving you those verbiage sort of things as we

move forward, so we can get through the video a little faster.

I just want you to know that often for

a journal entry, it's helpful if you do something like this.

If you are looking back on this months later, that little bit of verbiage may

make it a lot easier for you to remember what you were thinking over at the time.

Let's take a look at the T accounts.

So here, we're going to have to impact our cash T account and our rent T account.

Notice that the cash T account already has that $100,000 that occurred in our

first entry, so we're going to carry that forward.

Because remember, our T accounts are keeping a history of everything that's

going on at least during this period.

So now, how is the cash T account changed?

Well, it's gone down.

We credited it.

What side does credit go on?

It goes on this right side.

So, we scroll that going down for $24000.

Where do that cash go?

Well, it created this new asset.

Since that was a debit, we'll put that on the left side of the T account for $24000.

We're already moving on to transaction three.

It's going faster than I told you it would.

Now that we've got a space, a warehouse, we're going to get some equipment and

some fixtures to put in the warehouse.

The company that we're buying those equipments and

fixtures from, asked us to pay 14,000 upfront.

But they agree we can pay them 22,000 more at the end of 3 years.

That's about how long we think this equipment is going to last.

That way, we can be using it over time and

generate in the cash that we're eventually going to use to pay off this asset.

Now for this example, I'm going to ask you just to ignore interest.

If we were doing a real example, we'd have to think about what the interest means.

But to get the accounting cycle, we don't really need to know that.

So, let's get back to analyzing this transaction.

What's occurred here?

Well, we're going to start with cash again, that's always the easy part.

Our cash has gone down by $14,000, What else have we given up?

Well, we've given somebody a promise that we'll give up $22,000 more of cash

in three years.

So in total, that's $36,000 worth of cash over a three year period

that we're going to give up to people.

What are we getting in return here?

We're getting a bunch of equipment and fixtures.

We must think those are worth $36,000.

So let's do the journal entry.

We'll start with the cash part.

We're going to credit our cash balance, because it's going down.

Now we're also going to create a liability.

This is the first one of these you've seen.

The liability's going up, so we credit it as well.

We've got $36,000 worth of credits here, what's the debit side of this entry?

Well I'm going to call it Property Plant and Equipment.

Now if you wanted to be more specific and call it fixtures, or

specific type of equipment, that's probably what you would do on your books,

so you could track each one individually.

But for this example,

just doing it at this aggregate level of Property Plant and Equipment.

By the way, if you hear people talk about PP&E,

they just mean Property Plant and Equipment.

This works well for us.

Now again, we've got a nice journal entry.

The debts and the credits are equal to each other.

We've got our number three there so that we can track it over time.

We're going to skip the verbage though.

Now we've got three different T-accounts we have to impact.

We've got our cash account which is carrying the history of our

two prior transactions.

The first thing we're going to do is adjust our cash account,

since it was credited we're going to put that 14,000 on the right hand side.

Now we're going to reflect the fact we had this notes payable,

we owe people in the future.

That was also a credit so it goes on the right hand side for 22,000.

And then we debited property plant and equipment for 36,000.

So that goes on the left hand side.

Again notice how each one has the number 3 by it.

So if we have to comeback to this T-account at some point of the future and

figure out what was this one transaction,

we can just trace that right back to the journal entry.

Let's move on to the next transaction.

We're finally ready to start buying some books, so we will be able to sell them.

We buy $170,000 worth of books, and

the people who give them to us tell us you can pay us in three months.

This will give us some time to sell books so we'll have some cash to pay them with.

So how have we changed?

Well we have books now, those are inventory.

And we owe $170,000 three months from now.

Easy enough to analyze, let's go ahead and reflect that on our financial statements.

This is the first entry where we don't have any cash to start with, so

what's the easiest part to start with?

I think the inventory is, it's clear that we've physically got something,

and it's $170,000 worth of that stuff.

So we'll go ahead and debit that for $170,000.

And then we'll reflect a credit on accounts payable of $170,000 because at

some point in the future, we're going to to have to pay for

this inventory we were given.

Okay, let's look at how that goes into our T-accounts.

Well, $170,000 debit goes on the left side of the inventory T-account.

And this is our first activity in accounts payable.

Since it was a credit, it goes on the righthand side of the T-account.

Now we move on to the next transaction.

We makes sales of $225,000 of merchandise that originally cost us $140,000.

So we haven't sold all of our books yet but we've sold a lot of them.

That's pretty good news.

How does this change the company?

Well those sales were made on account.

So somebody's promised us they'll pay us in the future and

we've given up book of $140,000.

Pause and take a look at this transaction.

It's different than the first four transactions in a really important way.

The first four transactions were all answering just

that first question in life.

Where are we at a given point in time?

We hadn't interacted with our customers yet, so we hadn't created or

destroyed value in a way that would reflect in that second question.

What happened over this time period to create or destroy value?

Now we are moving on to that second question.

Notice that in the analysis I gave you, we focused more on that first question.

People owe us money and we gave up books.

That's because our brains find it easier to understand that

part of the transaction.

But we also need to reflect the fact that $225,000 of value has come in

from our customers, and we only had to use up $140,000 to create that.

This analysis is a little more complicated.

I like to use the journal entries to help me understand this analysis and

I like to break it down into two related transactions.

I'll start with the first part.

We had sales of 225,000 made on account.

So how did that impact the company?

225,000's owed to us now, and it came from interacting with customers.

So I'll start with the part owed to us.

That's the easiest part for me to think about.

My accounts receivable, which is an asset.

Probable future economic benefit, when they give me the cash.

Under my control, if they don't pay me I can sue them or

pursue them in some other way.

And there was a transaction, they came in and made that sale with me.

So it's an asset, I'm going to debit it for 225,000.

Where did that asset come from?

It came from revenue which, wow, is a revenue account,

notice the special word in brackets there, of $225,000 as well.

That handles the first part of the transaction, what I got and

where it came from.

Now I'm going to look at the second part of the transaction.

I didn't get this for free.

I no longer have $140,000 worth of inventory, and where did it go?

I had to use it up to create revenue.

So let me do that journal entry.

Again I'm going to start with the balance sheet, that's easier for me to understand.

I'm going to credit the inventory account to take out the 140,000

that I don't have any longer.

And then I'm going to debit the cost of goods sold, that's an expense, and

I need to reflect the fact that I had to use up that value to generate the revenue.

Now if we put these two journal entries together,

you'll start to see the answer to what happened over time.

We had $225,000 of value that came up, and

we had to give away stuff of $145,000 to get that value.

If we net these together, it says we had a gross profit of $85.000.

That's the extra value that we created by getting those books, breaking them into

smaller groups and convincing different book stores that they should buy them.

Now notice that I said gross profit.

There's still going to be other expenses we have to incur to run our business for

this period but on a gross basis we've created $85,000 of value.

Before I show you the T-accounts for

this, I want to show you an alternative way of doing this journal entry.

I prefer the way I just showed you but you're going to see these sometimes too.

This alternative way is called compound journal entires,

it's where we put it all together in one big transaction.

When people do this they usually just try to think of, what are all my debits and

what are all my credits.

Same exact analysis, but now, what are all my debits?

Well, my first debit, accounts receivable for 225,000.

My second debit, I had an expense for 140,000.

That gets me all my debits.

From a credit standpoint, I had revenue of 225,000 and

I had inventory of 140,000.

If you look at this, you'll see, I'm still capturing that 85,000 of gross profit.

Some people have told me they feel like doing it this way,

makes that income statement side of it clearer to them.

Personally, I prefer the way I showed you to begin with.

I think breaking it down that way really helps me think about economically what's

going on in the firm, but either one of these is fine.

Both are correct.

Whichever way is the best for

you in understanding what's going on is the way you should do it.

Now regardless of which way we did the entry,

let's think about how it impacts our T accounts.

Well, our accounts receivable were debited.

So, we're going to put that on the left-hand side for 225,000.

Our revenue was credited, so that goes on the right-hand side for 225,000.

We also need to change our inventory account.

Remember, we had a 170,000 balance in there.

But now, we have a credit of 140,000 that we'll need to put on the right-hand side.

And then we have an expense which was a debit in our journal entry, so

we're going to put that on our left hand side.

That's a $140,000 entry.

That's probably the toughest entry.

Let's move on to some easier ones.

In transaction 6, I've actually put two transactions together in one entry

just to make it seem like it's a little shorter for you.

Here, we collect 120,000 from those customers who

promised they would pay us at some point in the future.

So, let's analyze that one.

How did we change?

Well, we now have cash and

we no longer have that promise from people that they'll pay us in the future.

Let's go ahead and analyze the second part too.

We paid our suppliers 130,000.

Remember when we took that inventory,

we promised them we'd pay them within three months?

Well, we pay 130,000 of that off now.

So now from an analysis standpoint, we have 130,000 less of cash.

But we also no longer owe people 130,000.

Those were both pretty easy to analyze.

Let's go ahead and do the journal entries.

Starting with the 120,000 of cash that we collected from our customers.

We'll start with the cash again.

Since this asset went up, we'll debit that and then the credit.

Well, we no longer have that asset called accounts receivable.

The overall size of our company doesn't changed.

We just changed from one asset, accounts receivable into another asset cash.

Now the next transaction, I'm again going to start with the cash.

But we're going to credit the cash, because it's gone out of the company.

So, our cash goes down by $130,000 and

our accounts payable also goes down by $130,000.

Notice in this entry, the size of the company actually changes.

Our assets get smaller by $130,000 and

our liabilities get smaller by $130,000.

So, we're shrinking the company by moving those resources outside of the company.

Let's put them in the T accounts.

Now, you can see our cash T accounts starting to get more and

more detail in it.

We're going to need to add that 120,000.

Since it was a debit, it goes on the left.

Our accounts receivable T account is going to be credited by $120,000.

So, that goes on the right.

Now when we move onto the second transaction,

we're still going to use the cash T account and that was a credit.

So, we put that 130,000 on the right and we're going to need

to put the debit of 130,000 on the left of the accounts payable balance.

Now, we're ready to move onto the ext transaction.

We've hit the end of the month, it's the last day of work in January.

As your employees head out the door, they say, hey,

boss, don't forget, tomorrow is pay day, you owe us $5,000.

Now they wouldn't really do that, but

remember I'm trying to show you these externally generated transactions.

And so, something has to have happened to make you think of it.

Otherwise, this would go in those adjusted entries and

I just thought it would easier to have it here at this time.

So you've gotten to the end of the month and you think about this and say,

let me analyze it.

What's happened?

Those employees worked all month, what did they do?

Well, they moved the books around.

So, they would be where the customers want them.

Maybe when a customer came in,

they talked with the customers about what books they should buy, etc.

Whatever value we were going to get out of what they did this month is done.

They weren't building anything new or created anything for the future.

So, all $5,000 that we owe them is leaving the firm as an expense.

We know that we've used up $5,000 of value during this month.

What's the other side of it?

Well, we haven't paid it yet.

So, we owe them.

So, we're also going to reflect the fact that we owe somebody some money.

Let's go ahead and do that journal entry.

We'll start with the wage expense.

It's a debit balance like any other expense, reflecting the fact that values

gone out of the company and then we've got wages payable like our other liabilities.

An increase in the liability is a credit balance of $5,000.

Take a look at this journal entry.

Notice there is no cash that occurred, but

we've still reflected the fact that values has been used up by the company.

Let's go ahead and put this in T accounts now.

Notice our wages payable account didn't had anything in it.

In our journal entry, we credited wages payable.

So, that's going to go on the right-hand side of T account.

Now, I'm going to use just one expense account.

We could have a separate expense account for cost of goods sold, for wage, etc.

But to make this easier when we get into one of the later videos,

we're just going to accumulate all the expenses in one T account.

So, we had a $5,000 debit to the expense.

That means that is goes on the left-hand side, adding more to the activity and

the expense T account.

Just one more transaction and we're done with this video.

At the end of the period, we took a look at everything that had gone on.

And we said, hey, we think we can pay a dividend to our shareholders.

What does this do as far as impacting the company?

That is how do we analyze this?

Well, we no longer have cash and we've returned some value to our shareholders.

So, we know we're down cash.

And if we think about what's happened here, we didn't use up value to create

a sale, rather we just gave something back to our shareholders.

So, we haven't really created an expense.

We've just impacted where we stand right now.

Let's do the journal entry and maybe that will make it clearer.

As always, let's start with the cash part.

Since the cash is left, we're going to credit the cash account for $12,000.

Now, what's the other side of that entry?

Well, we're going to put that toward retained earnings.

Basically, what we're saying is we're giving a portion of the earnings

we've made this period back to the shareholders.

Since they really own the company, we're no longer going to retain those earnings.

That's why we are going to debit this.

Remember, equity accounts normally have a credit balance.

The debit here is saying, we're taking out some of the earnings that we've made and

taking those out of the company.

If that's not entirely clear, that's okay.

Because there is an entire video that's going to cover that for you.

From the journal entry standpoint, we're all set now.

We've credited cash.

We've debited retained earnings.

How do we put those into T accounts?

Well, we've got that cash T account.

Notice there's been an awful lot of activity in there.

We had a credit to cash, so we're going to put that on the right-hand side and

our retained earnings T account.

We haven't touched that yet, but we have a debit now of $12,000.

We'll come back to that retained earnings T account in some future videos to figure

out what else has gone on there.

Congratulations, you've gotten all the way through the initial transactions.

In the next couple videos, we're going to think about which accounts need to be

adjusted, then we'll do another video on how to close this things out and

a third video to create a set of financial statements.

Thanks for hanging in there with me.

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