Hey, managers. It's likely that you, yourself, will not be recording transactions using journal entries. The accountants in your organization will be doing that. Yet, it is critical for you to understand the impact of your decisions and the resulting transactions on the financial statements of your organization. Now, certainly understanding how to record journal entries and use T-accounts will help you assess the impact of your decisions on those statements. But ultimately, you will learn to assess that impact more intuitively. Not by recording a journal entry per se, but by envisioning how the financial statements change with each decision you make. So let's talk about the differences and how the day-to-day accounting happens, and how you might think about all of this. Let's take a look at transactions from the Garden Spot case. For each transaction, let's record the effect of the transaction on each of the financial statements. And to record each transaction, you still need to know the same four things that you needed to know to record a journal entry. You've got to know the accounts affected, the type of the account, whether it's an asset, a liability, or an owner's equity account, whether the balance in that account increases or decreases, and the dollar amount associated with the transaction. However, rather than writing out a journal entry and then posting it to a T-account, we will simply indicate the effect directly on the financial statements themselves. Let's start with an income statement and a balance sheet and work though each transaction in the case. I'm going to show you how to envision the changes to the financial statements. In the first transaction, Mary Jo and Josh invested $60,000 in the company in exchange for shares of common stock. When they made that investment, the company's cash account when up by $60,000, and its capital stock account goes up by $60,000. So, I add each of those accounts onto the balance sheet and show the effect on each the respective accounts. After recording that transaction, the balance sheet looks like this. We have $60,000 in assets. We have $60,000 in liabilities and owners equity. Let's move to the second transaction. In the second transaction, the company obtained a $40,000 loan from the bank. When they obtained the loan, the cash account on the balance sheet went up by an additional $40,000, and the company must show a liability, a loan payable on its balance sheet for $40,000. So in this transaction, our Assets go up by $40,000 and our Liabilities and owner's equity go up by $40,000. After we've recorded the effect of that transaction, we see that we have now $100,000 in Assets, and we have a $100,000 in Liabilities and owner's equity. 40,000 of that is a liability for the loan, $60,000 of that is the capital stock that was issued to Mary Jo and Josh. Lets go to the third transaction. The company purchased a truck for $12,000 in cash. Well, the cash account goes down by $12,000 because that's what the company spent to buy the truck. And it's property, plant and equipment account will go up by $12,000. One asset goes down by 12,000, one goes up by 12,000. The net effect is zero, so the effect on both sides of the balance sheet is a zero. So we remain in balance. The balance sheet, after recording that transaction, shows a cash balance of 88,000, and property, plant and equipment of 12,000, for total assets of 100,000. And we still have 100,000 in liabilities and owner's equity. Very similar transaction, the company purchased equipment for $10,000 in cash. We won't spend a lot of time on this. It looks basically just like the prior transaction. Cash is down by ten, property plant and equipment is up by ten. And so, we reduce the cash balance here to 78, and the property plant and equipment balance increases to 22,000. The next transaction, the company purchased inventory throughout the year costing $260,000. 235,000 of that was paid by cash, and remaining 25,000 was purchased on account. Here, the company bought inventory, so the inventory account needs to be put onto the balance sheet, and its balance goes up by $260,000. We need to record that the cash balance goes down by 235,000 because that's what the company paid in cash. And then we will have a new obligation or a new liability account on the balance sheet that increases by $25,000. Here are the net effect on the asset side of the balance sheet is $25,000 increase. That's the same as the increase on the liability and owners equity side of $25,000. After we record that transaction, then the balance sheet shows a negative cash balance. We'll talk about that in a moment, but total assets of 125,000 and total liabilities and owner's equity of 125,000. Is it practical for a company to have a negative cash balance? No, it's not. But let's just think about the transaction that we just recorded. What we recorded was that the company purchased inventory throughout the year. So we are essentially sitting at the end of the year, recording the summary of all the purchases that have happened throughout the year. And at some point in time throughout the year, the company's generating sales, and so cash is coming in, so they have plenty of cash to cover those purchases. So, importantly, this is the summary transaction at the end of the year that captures the effect of purchasing all the inventory that was bought throughout the year. Let's go to the next transaction. Here, the company records sale of $400,000. 315 of that was cash sales. The remaining 85,000 were sales on account. We know that when we record revenues or sales, the increase is to the retained earnings account on the balance sheet. So we'll add that retained earnings account onto the balance sheet, and we'll show it increasing by $400,000. Remember that cash sales were 315, so cash balance goes up by $315,000. 85,000 of that was sales on account, so the accounts receivable balance goes up by $85,000. We need to make sure we have that account on the balance sheet. The total effect on our asset accounts is that they increase. Assets increase by $400,000, which is exactly equal to the increase in the liabilities and owner's equity side of the balance sheet with our increase to retained earnings. Now, in this situation, the income statement comes in to play because we have revenues that we're recording. Now remember, we record revenues and expenses directly to the retained earnings account on the balance sheet. But it's important for us to envision the path they take to get to retained earnings is through the income statement. The top of the income statement, we see revenues. Revenues increased here when we made those sales, which has the ultimate effect on net earnings of increasing net earnings by $400,000. And that is how we get the $400,000 effect on retained earnings. Now, let's deal with the issue that the inventory sold had originally cots $240,000 In this transaction, we recognize that the company provides inventory to its customers. It sold inventory to its customers, so its inventory balance must go down by the cost of the inventory that was sold to the customers. That inventory cost the company $240,000 originally, so we reduce the balance in the inventory account by $240,000. As we did with sales, we are going to record the effect of expenses associated with those sales on the retained earnings balance on the balance sheet. So, our retained earnings goes down by the cost of the inventory sold. How does that ultimately affect retained earnings? Well, recall that expenses go on the income statement. So we'll record on the income statement an expense, I've called it cost of goods sold. We could call it cost of the inventory we sold to the customer, but the important thing is it's an expense. That expense goes up by $240,000. That ultimately affects net income by reducing net income by $240,000. And it is through net income that this 240 has made its way into the retained earnings account. Here is what the financial statements look like after having recorded all of these transactions. So now, we're starting to see the accumulation of some revenues and some expenses on the income statement. And so to date, we've recorded net earnings of $160,000. The next transaction, the company incurred operating expenses of $140,000 and it paid those all in cash. Relatively straightforward, the cash account goes down by $140,000, retained earnings goes down by $140,000 for that expense. The operating expense shows up on the income statement which serves to reduce net income, which is how that negative 140 ends up affecting the retained earnings account. Now, we see the picture, the financial picture, after having recorded that transaction. Again, just making sure assets still equal to liabilities plus owner's equity. The next transaction. The company made a payment to the bank of $14,000. $10,000 of that was to reduce the principal, or to pay back some of the principal, and $4,000 of that was payment for interest. So, cash must go down by $14,000 because that's what the company paid to the bank. We reduce the loans payable balance, the liability, by 10,000. The company now owes 10,000 less to the bank. And the interest is an expense, so it reduces the retained earnings account by $4,000. Assets are down by 14,000, liabilities on owners equity are down by 14,000. So, our balance sheet equation remains in balance. Now remember, interest expense goes on the income statement because it is an expense. It serves to reduce our net income by $4,000, which is how the retained earnings balance ultimately decreases as a result. We're accumulating more information into these financial statements. We're still seeing that assets is equal to liabilities plus owner's equity. In the next transaction, we see that employees did work in December for which $5,000 would be included in their January paycheck. Well, we know that if we haven't made a payment to those employees, we have an obligation to make a payment, so we have a liability that we'll call here wages payable. Or we could call it money that I owe to my employees that they will be paid in December. But importantly, it's a liability. That liability increases by $5,000. The wage expense affects retained earnings by reducing it. Remember that we have to match the expenses that we incur in the current period to the revenues that they helped us generate in the current period. So, very important to make sure this wage expense is recorded on this year's income statement. That wage expense, again, like all others expenses, reduces net earnings. Which has the ultimate effect of the reduction in retained earnings that we've recorded here. Our liabilities are up by 5,000, our owners equity is down by 5,000. That side of the balance sheet remains unchanged, so our balance sheet remains in balance. And this is what the financial statements look like after having recorded that transaction,. Now, let's record deprecation expense on the truck and the equipment. Recall, again, that it's important for us to take all the cost that we've incurred to generate this period's revenues and record those costs as expenses on the income statements to match the expenses to the revenues they help us generate. And depreciation is an example of this. The cost of using the truck and the cost of using the equipment is a cost we incurred to generate these period's revenues. So we've got to record some cost for using those on this year's income statement. We used part of the truck and the equipment, so we're going to reduce the property plant and equipment account. To recognize that we've used part of that and we're going to record it as an expense on the income statement. That expense reduces retained earnings by the same amount. We see on the income statement that we've included that Depreciation Expense of $4,400, which reduces net income, which then, of course, is how we see this reduction in retained earnings of $4,400. We're getting close. We've almost recorded all the transactions for the year. And we haven't even recorded a journal entry or used a T-account. Again, we're taking that manager's view point. All right, let's take a look at the payment of taxes. The company paid $990 in income taxes. So, cash goes down by 990 because the company actually wrote the check and send it into the tax authorities. We have a tax expense that reduces retained earnings of $990. The tax expense we see on the income statement, it's an expense of the current period. We have to record it on the income statement at the same time we've recorded the revenues. So, it serves to reduce net earnings by $990 which, again, is how we got to the 990 reduction in retained earnings. So then, we arrive at the income statement and the balance sheet after having recorded all of those transactions. You'll notice, if you compare the income statement and the balance sheet we have here to the income statement and the balance sheet that we derived when we were recording these transactions using journal entries and T-accounts, that they look exactly the same. Previously, we had taken the accountant's approach and recorded these transactions using journal entries and T-accounts. Now, we've tried to use a manager's intuition to infer the effects of those transactions on these financial statements. We end up in the same place. We end up with net earnings of $5,610, and assets equaling liabilities and owners' equity of $125,610. So, now you know how to envision the impact of your decisions as a manager on the financial statements. Again, you should note that the resulting balance sheet and income statement is exactly the same as the ones that the accountant built as a result of recording journal entries, posting those entries to T-accounts, and using the T-accounts to help construct the financial statements. We've just, again, taken a more intuitive managerial approach in this segment.
