-Topic 2 Accounting Equation

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Topic 2 Accounting Equation

ABAB113Business AccountingSemester 1 2014/2015

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Basic Accounting Equation

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The resourcesowned by a

business

Assets = Liabilities + Equity/Capital


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The rights of thecreditors are the

debts of thebusiness.

Assets = Liabilities + Equity


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The rights of theowners

Assets = Liabilities + Equity


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An asset is a tangible or intangible resource that isowned or controlled by an accounting entity, andwhich is expected to generate future economicbenefits (e.g. plant & machinery, office equipment,inventories, trade receivables, cash).

A liability is a legal obligation to transfer assets orprovide services to another entity which arisesfrom some past transaction or event (e.g. loans,

trade payables).Capital is the proprietors ownership interest in thebusiness or net resources of the business.


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Example 1

A. Brown commenced business on the 1 January 20X2with RM10,000 in cash:

A. Brow n

B alanc e sheet at 1 Janu ary 20X2 RM

Assets:Cash 10,000Less : liabilities 0Capital 10,000

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On 2 January he bought goods for resale costing RM3,000on credit:A. Brow n B alanc e sheet at 2 Janu ary 20X2

RMAssets:Cash 10,000Inventories 3,000

13,000Less : liabilitiesTrade payables 3,000Capital 10,000

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Example 2


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On 3 January he sold the goods on credit for RM4,000:A. Brow n

B alanc e sheet at 3 Janu ary 20X2 RM

Assets:Cash 10,000Trade receivables 4,000

14,000

Less : liabilitiesTrade payables 3,000Capital 11,000

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Example 3


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Analysis of transactions using accountingequation

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Abusiness tr ansaction

is an economic event orcondition that directly changes an entitys financialcondition or its results of operations.Refer to p.16


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Expanded Accounting Equation

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The Expanded Accounting Equation breaks out theOwners Equity section into two components;Revenues and Expenses.

Revenues from the sale of goods and services increaseequity, while expenses and drawings incurred in thecourse of business decrease equity.Drawings occur when the owner of the business takewhatever assets for his/her personal use such as cash,goods etc.


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Expanded Accounting Equation

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Therefore, the accounting equation can be expandedto assets equal liabilities plus equity plus revenuesminus expenses minus drawings.If the business makes profit:

A = L + (Capital + Profit)A = L + Capital + Revenue ExpensesA = L + Capital + Revenues Expenses DrawingsOR;

A + E = L + C + R


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Revenue expenditure v capital expenditure

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Capital - items that appear in the balance sheetRevenue - items that appear in the incomestatement.Expenditure of the type which is to be matched againstthe periods revenue and is used up in the period is

identified as revenue expenditure .have no value at the end of the period to which itrelates.for example, heat and light, rent, rates, etc.

Capital expenditure - amounts which it is appropriate tocarry forward as part of the next years openingstatement of financial position.

because it will be used over a number of periods andcontributes to several periods revenues.Premises, motor vehicles, fixtures and fittings, etc.


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Rules of debit and credit

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Double-entry bookkeeping is a systematic method ofrecording an enterprises transactions in a bookcalled the general ledger. Each page of the ledger issplit into two halves:

Left half debit sideRight half credit side

There is usually an account for every class ofexpenditure, income, asset, and liability.


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T-account Account nameDate Description RM Date Description RM1 Jan Bank 900


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Debit and credit balances, and types/classes ofaccountsWhen the total amount of money on the debit side of anaccount is greater than that on the credit side, theaccount is said to have a debit balance. When thereverse is the case, the account is said to have a creditbalance.

An account with a debit balance represents eitherdrawings , an asset (e.g. cash), an expense (includingpurchases) or a loss .

An account with a credit balance represents eithercapital , a liability, income (e.g. sales) or a gain .


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Posting updating the accounting records withtransactions3 steps

1. Determine the 2 accounts affected.

2. Consider the flow of value (when the value leaves anaccount it is credited, when the value enters anaccount it is debited).

3. Identify the money value that is transferring.


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Which accounts do you debit and credit?a) Bought office machinery in cashb) Bought lorry for cashc) A loan of RM200 is received by cheque from Earlsd) Paid stationery by chequee) Paid rates by cashf) Sale of goods for RM100 cash on 3 Feb.

The value enters cash a/c (DEBIT) and leaves sales a/c (flow ofinventory out) (CREDIT).


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Introduction to Financial Statements

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After transactions have been recorded andsummarized, reports are prepared for users. Theaccounting reports providing this information arecalled financial statements .

Income statement/Statement of comprehensive incomeBalance sheet/Statement of financial positionCash flow statement


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The income statement provides a summary of the resultsof a business's trading activities during a givenaccounting year. It shows the profit or loss for the year.

to enable users, such as the owner(s), to evaluate thefinancial performance of a business.


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The structure of income statement

A B CInc om e s ta tem ent for th e year ended. .

RM RMRevenue XLess : cost of sales/goods sold XGross prof i t X

Add: Other IncomeDiscount received X

XLess : other costs and expenses -

Selling and distribution costs XAdministrative expenses XInterest payable on loans X

XProf i t /(Lo ss) for the per iod X


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Balance sheet is a list of the assets, liabilitiesand capital of a business at the end of a givenaccounting year.It provides information about the resources and

debts of the reporting entity. This enables usersto evaluate its financial position, in particularwhether the business is likely to be unable to payits debts.


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The contents of balance sheet1. Non-current assets

Items not specifically bought for resaleItems to be used in the production or distribution ofthose goods normally sold by the business.Durable goods that usually last for several yearsThere must be an intention to keep them for more thanone accounting year

Examples

Land and buildings; plant and machinery; motor vehicles;office equipment; furniture, fixtures and fittings.

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The contents of balance sheet2. Current assets:

Items that are normally kept by a business for less thanone accounting year.The composition of each type of current asset isusually continually changing.

ExamplesInventories, trade receivables, short terminvestments, money in a bank cheque account andin cash.

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The contents of balance sheet

3. Current liabilities Debts owed by a business that are payablewithin one year (often considerably less) of thereporting period date; e.g. trade payables andbank overdrafts.

4. Non-current liabilities These are debts owed by a business that are notdue until after one year (often much longer) ofthe reporting period date; e.g. loans andmortgages.

5. Capital (Equity) This refers to the amount of money invested inthe business by the owner(s).

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The structure of balance sheet

A B C S d n B h dBalan ce sh eet as at ...

Non-current assets+

Current assets=

Total ass ets

=

Equity and Reserves+

Non-current liabilities+

Current liabilities=

Total equi ty and l iabi l i t ies

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Cash flow statementdiscloses net cash flow for a particular period.lists out the various sources from which the businessreceives cash and how the cash is spent i.e. the

liquidity of the business.contains information about operating, investing andfinancing activities.further details to be revisited in Topic 5

-Topic 2 Accounting Equation

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