Accounting Equation Effects and Fundamental Principles
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Question No:01 (04 Marks)
A few business transactions carried out by Smalling Manufacturing Company are as follows:
a) Borrowed money from a bank.
b) Sold land for cash at a price equal to its cost.
c) Paid a liability.
d) Returned for credit some of the office equipment previously purchased on credit but not yet paid for.
Indicate the effects of each of these transactions on the total amounts of the company’s assets, liabilities, and owners’ equity. Organize your answer in tabular form, using the following column headings and the code letters I for increase, D for decrease, and NE for no effect. (Hint: Asset = Liability + Owner Equity)
Question No:02 (06 Marks)
Answer the following questions:
1. Land is listed on the balance sheet at its market value of Rs. 1,000,000. It cost Rs. 670,000 to purchase 12 years ago. What is appropriate value at which land should be recorded?
2. Differentiate between Cash Accounting and Accrual Accounting.
3. Hassan Builders completed plans for guesthouse, pool and spa for a client. The $5,700 fee for this project was billed to the client in May, but will not be collected until June 25. Should Hassan Builders record this amount as revenue or expense, and in which month should it be recognized?
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Step by Step Written Solution
In this video, we will solve the first two questions from this accounting midterm. Let's start with Question one, which asks us to analyze business transactions for the Smalling Manufacturing Company.
Question 01: Transaction Analysis
We need to indicate the effect on Assets, Liabilities, and Owners' Equity using:
- I for Increase
- D for Decrease
- NE for No Effect
Let's look at transaction A. The company borrowed money from a bank. This means the business now has more cash, which is an asset, and it also has a new obligation to pay back the bank, which is a liability.
Transaction A: Borrowed money from a bank
Since cash increases, Assets increase. Since the debt increases, Liabilities also increase. There is no impact on the owners' personal investment or retained earnings yet, so Equity has no effect.
Transaction B involves selling land for cash at a price equal to its cost. This is an exchange of assets. One asset, land, goes away, while another asset, cash, comes in.
Transaction B: Sold land for cash at cost
The increase in cash exactly offsets the decrease in land. Therefore, the total amount of Assets remains unchanged. Liabilities and Equity are not affected by this swap.
In transaction C, the company paid a liability. This means using up cash to reduce what is owed to a creditor.
Transaction C: Paid a liability
Cash, an asset, decreases. The liability also decreases as the debt is settled. There is no change to Equity.
Finally, transaction D shows returning office equipment previously purchased on credit. This reverses the purchase.
Transaction D: Returned equipment for credit
When we return the equipment, our assets decrease. Because we haven't paid for it yet, the creditor reduces our bill, so our liabilities also decrease.
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