[NOISE] Hello, welcome to second class of Financial Accounting Foundations here at University of Illinois. Today we are going to talk about recording financial transactions and prepare additional financial statements. Here is a bit of an overview of what we are going to do today. First we will see the principles and some examples of how we record financial transactions. In other words how we write financial transactions in accounting language. And then from these recorded financial transactions we will learn how to prepare balance sheet and income statement. What is the guiding principle behind recording financial transactions? To understand this, we need to go back to fundamental accounting equation. Under fundamental accounting equation, total assets are equal to total liability plus shareholder's equity. Therefore, it must be true that for a certain period of time, let's say for a year, changes in total assets are equal to changes in total liabilities plus changes in shareholder's equity. So here in this formula the delta stands for change. And this is true for an ytime period. Basically for example for a five year period, if there is an increase in total assets of $1000, it must be the case that between this five year period either total liabilities or shareholders equity or a combination of them should increase by $1,000. And this constitutes the main logic behind recording financial transactions. So how are we going to do the financial transaction recording? First we are going to identify the accounts impacted by this financial transaction, and then we will worry about the amount that we need to record for these accounts. And finally, we have to ensure that fundamental accounting equation holds. So, total assets must be equal to total liabilities plus shareholder's equity. Here is a small example. We have a firm here, purchasing a truck for $65,000 using a bank loan. So let's go through a step-by-step how are we going to record this individual financial transaction. The first step is, this transaction impacts which accounts? Well, we are buying a truck, which is a fixed asset. So basically assets will go up. And secondly, we're buying this truck by getting a bank loan, bank loan is a liability, therefore there will be also an increase in liabilities. The second step in recording financial transactions is what is the amount? No wonder it is about $65,000 and therefore because of this transaction, what's going to happen? Assets, in particular, fixed assets, will go up by $65,000 and liabilities, in particular, bank loans, will go up by $65,000. The third step is, we have to ensure that fundamental accounting equation holds. Total assets increase by $65,000 and at the same time total liabilities also goes up by $65,000. There is no change in shareholders' equity, and yes, fundamental accounting equation holds. From now on, in order to record these individual financial transactions much more systematically, we are going to use something called transaction worksheet. So here is an example of what it looks like in the transaction worksheet. We have assets equal to liabilities + shareholders' equity. This is our fundamental equation. And then we have opening balances. Most of the time, whenever you start a year or a quarter. Most of the accounts we have on the accounting system have some beginning balances and then there are a bunch of transactions within this time period, again it can be a quarter of an year. And at the end of this time period we are going to sum opening balances as well as the transactions between the time period, so that we can come up with closing balances. So if we go back to our Example 1, a firm purchases a truck for $65,000 using bank loan. How are we going to record this on the transaction worksheet? There will be an increase in assets, in part the fixed asset of $65,000. And then there will be an increase in liabilities of $65,000 in the form of bank loan. You will have to always ensure that fundamental accounting equation holds. Total asset increase by $65,000, and total liability is also increased by $65,000. There is no change in shareholders' equity, and yes, fundamental accounting equation holds. Let's do one more example, a firm sells goods which originally costs $1,000 for 1,500 in cash. What were the first step of recording this financial transaction? First which accounts are impacted? But it looks like we are making a sale in cash, so cash will be impacted. Second of all, we are making a sale so revenue will be impacted. And then we are selling a good, so we don't own this good anymore, so inventories will go down. And then this inventory decrease will be recorded as expenses. So let's record this. What's the first step of recording this transaction? You are making a sale of $1,500 in cash. So assets which in part to go to cash will go up by $1,500, and revenues will also go up by $1,500. Let me mention something very important here. Revenues, or expenses will be represented in income statement. An income statement is represented on transaction worksheet under shareholders' equity. We are going to go through this in detail later but for now you need to remember that any account which in pay becomes capable will be represented under shareholders' equity or for transaction worksheet. What is the next stage? We are selling some goods which originally cost $1,000 therefore, there will be a reduction in inventory, which is an asset account of $1,000. And then there will be a recording of the cost of goods sold, or an expense on income statement of $1,000. So what was the first step? You have to ensure that fundamental accounting equation holds. The net change in total assets for this transaction is 1,500 minus 1,000 which is an increase of $500. And what is the net change in the liablities plus shareholder's equity size? It is again plus $500 and yes, fundamental accounting equation holds. Here is another example, a firm receives a utility bill for $850, so what was the first step of recording this transaction, which accounts are impacted? Well we are getting a utility bill, it's an expense, so it's going to impact income statement, which is a shareholders' equity item. But are we paying for this bill? Not really. All we are doing is we are getting the bill. Therefore, we are going to getting the notice to pay this thing in the future. Therefore it's going to be recorded as a liability. So this is going to be recorded as a payable. So how are we going to record this transaction? There will be $850 on shareholders' equity, which is the expense associated with income statement. Notice that this number is in parentheses. Parentheses represent an accounting negative number. And similarity, we are not paying this bill, all we are getting is the notice of paying this bill, therefore we are going to record a liablities of $850. It's a liability. It's a positive number. What was the next step of recording financial transactions? You have to ensure that fundamental accounting equation holds. The net change in total assets associated with this transaction is zero. And what is the net change in liabilities plus shareholders' equity? That is a positive $850 for liability increase, and then there is a loss or expense recording of $850 on the shareholders' equity. Net liablilities plus shareholders' equity changes by zero. And therefore fundamental accounting equation holds. Now what we are going to do is, that we are going to through a long example to insure that we are very comfortable with recording financial transactions.
