Accounting Equation Service Business 6

8/8/2019 Accounting Equation Service Business 6

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Mary Low

Accounting Equation(Service business)

Waikato Legal Services

Mary LowWaikato Management SchoolThe University of Waikato


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The framework

The accounting equation can be said to theframework for the entire accounting process.

The accounting equation is an essential building block of accounting.

The accounting equation is the basis of all accounting systems.

The accounting equation can be used to illustrate simply the

double entry system of accounting.

The two sides of the equation must be equal.

The accounting equation is also called the balance sheetequation.


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The basic elements

The two basic elements of any organisation are what itowns and what it owes.

What it owns are the organisations economic resources. Theseeconomic resources are used to help the organisation generaterevenues. In accounting, these economic resources are called

ASSETS.

Examples of assets for an organisation are:

Cash

Inventory

Accounts Receivable

Land & Buildings

Motor Vehicle

Furniture & Equipment


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The basic elements what it owes

What it owes are the organisations sources of financing for the economicresources.

The main source of financing usually comes from EQUITY. Equityindicates the amount of financing provided by owners of the organisation.

The next source of financing comes from debt. Debt is the result of theorganisation purchasing goods, services or assets on credit. Debt alsoresults from loan borrowings. Debt is given the term LIABILITIES.

Examples of equity for an organisation are:

Owners Equity / Proprietorship for a sole trader business

Partnership Funds for a partnership business

Shareholders Equity for a company business

Examples of liabilities for an organisation are:

Accounts Payable

Loan Payable


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The accounting equationwhat it owns = what it owes

Assets = Liabilities + Equity

A Balance Sheet (Statement of Financial Position) shows thatthe assets of an organisation should equal to its liabilities plusequity.

This is why the accounting equation is also called a balancesheet equation.


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Different versions of the accounting equation

The accounting equation can be expressed in anumber of different ways:

Asset emphasis:

Assets = Liabilities + EquityLiability emphasis:

Liabilities = Assets Equity

Equity emphasis:Equity = Assets - Liabilities


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Running a business

- its main objective Businesses usually operate with the objective of

making a profit.

Profit is determined by looking at two other

elements. These financial elements relate to revenue

(income) and expenses

Profit is determined by subtracting expenses

from revenues (income) i.e. Profit = Revenue - Expenses


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Profit

Any profits made by a business will go tothe owner. Therefore, revenue (income)and expenses effects are usually shown

under the Equity section of the accountingequation. An increase in revenuesrepresents an increase in profit andtherefore an increase in Equity. An

increase in expenses represents adecrease in profits and therefore adecrease in Equity.


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Transaction 1

Transaction 1: Investment by owner. Ace Lawyer opens the WaikatoLegal Services firm in Hamilton by investing $20,000 cash into thebusiness.

The transaction results in an increase in the Cash Asset and anincrease in Equity.

We note that the equation remains in balance, i.e. A = L + OE

Assets = Liabilities + Owners Equity

Cash Capital

+$20,000 +$20,000


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Transaction 2 Transaction 2: Purchase of equipment on credit. Ace purchases

equipment on credit from Computer Equipment Ltd for $9,000 (creditterms: 180 days). The transaction results in an increase in the Computer Equipment

Asset and an increase in Liability. We note that the equation remains in balance,

i.e. A = L + OE

Assets = Liabilities + OwnersEquity

Cash + Equipment AccountsPayable

Capital

Old bal. $20,000 $20,000

Trans 2: + $9,000 +$9,000

New bal. $20,000 + $9,000 = $9,000 + $20,000

Total: $29,000 = $29,000


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Transaction 3 Transaction 3: Purchase of $1,500 of stationery supplies for use in the

business. $1,500 cash was used to pay for this purchase. The transaction results in an increase in Supplies on Hand Asset and a

decrease in the Cash Asset.

Assets = Liabilities +Owners

Equity

Cash + Supplies + Equipment

on Hand

AccountsPayable

Capital

Old bal. $20,000 + $9,000 = $9,000 + $20,000

Trans 3:

- $1,500 + $1,500New bal. $18,500 + $1,500 + $9,000 = $9,000 + $20,000

Total: $29,000 = $29,000


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Important Note:

There are two ways that we can choose to record stationery supplies.1. We can record the supplies initially as an asset until they become used up.When supplies on hand become used up, they should then be recorded asan increase to Stationery Supplies Expense. When this happens, we willneed to decrease Stationery Supplies Asset and decrease Equity. Becausewe do not have a separate expense heading in the accounting equation: A =

L + OE, expenses will need to be deducted from Capital.This first approach has been chosen in this illustration to explain the effectson the accounting equation where stationery supplies are initially purchasedfor use in the business.

2. Stationery supplies can initially be recorded as an expense. For thisillustration, the effect of this second approach will be to initially decrease

Equity (Expenses decrease Equity) and to decrease cash Asset. At the endof the accounting period, the amount of stationery supplies that is on hand(not used up) will need to be recorded as an asset. To record the unusedsupplies, Stationery Supplies Expense will need to be decreased (note: toshow an expense decrease in the accounting equation: A = L + OE, Equitywill need to be increased) and Supplies on Hand Asset will need to be

increased.


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Transaction 4 Transaction 4: $1,000 in legal services were provided for cash.

We can straight away see that the transaction results in an increase in theCash Asset by $1,000 and an increase in the Legal Services Revenue accountby $1,000.

We note that the equation does not have Revenue heading, i.e. the equation is given as: A = L + OE

As we explained earlier, the effect of a revenue increasing will need to beshown as an increase in Equity.


Cash + Supplies + Equipment

on Hand

AccountsPayable

Capital

Old bal. $18,500 + $1,500 + $9,000 = $9,000 + $20,000

Trans 4: +$1,000 +$1,000

New bal. $19,500 + $1,500 + $9,000 = $9,000 + $21,000

Total: $30,000 = $30,000


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Transaction 5 Transaction 5: Legal services of $2,500 were provided on credit to a

client, Keith Queen.

The transaction results in an increase in an Account Receivable Assetby $2,500. Keith Queen owes $2,500 to Waikato Legal Services. He isan Account Receivable and therefore recorded as an asset to thebusiness. Although no cash has been received from providing legalservices, $2,500 of Legal Services Revenue have been earned

(Accrual concept) and will increase Equity.


Cash + Accounts Receivable + Supplies +Equipment

on Hand

AccountsPayable

Capital

Old bal. $19,500 + $1,500 + $9,000 = $9,000 + $21,000

Trans 5: + $2,500 +$2,500

New bal. $19,500 + $2,500 + $1,500 + $9,000 = $9,000 + $23,500

Total: $32,500 = $32,500


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Transaction 6

Transaction 6: Paid Accounts Payable. Ace makes a$3,000 partial debt repayment to Computer Equipment Ltd.

The transaction results in a decrease to Cash Asset and a

decrease to Accounts Payable Liability.



on Hand

Accounts

Payable

Capital

Old bal. $19,500 + $2,500 + $1,500 + $9,000 = $9,000 + $23,500

Trans 6: -$3,000 - $3,000

New bal. $16,500 + $2,500 + $1,500 + $9,000 = $6,000 + $23,500

Total: $29,500 = $29,500


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Transaction 7

Transaction 7: Received from Accounts Receivable.Keith Queen pays $500 on account owing to WaikatoLegal Services

The transaction results in an increase to Cash Asset and a

decrease to the Accounts Receivable Asset.



on Hand

AccountsPayable

Capital

Old bal. $16,500 + $2,500 + $1,500 + $9,000 = $6,000 + $23,500

Trans 7: + $500 - $500

New bal. $17,000 + $2,000 + $1,500 + $9,000 = $6,000 + $23,500

Total: $29,500 = $29,500


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Transaction 8 Transaction 8: Drawings by Ace Lawyer. Ace decides to take $2,000

cash from the business for his personal use.

The transaction results in a decrease to Cash Asset and a decrease toCapital Equity. Any withdrawals of assets by the owner from hisbusiness for his personal use will cause a decrease in his investment inthe business.



on Hand

Accounts

Payable

Capital

Old bal. $17,000 + $2,000 + $1,500 + $9,000 = $6,000 + $23,500

Trans 8: - $2,000 -$2,000

New bal. $15,000 + $2,000 + $1,500 + $9,000 = $6,000 + $21,500

Total: $27,500 = $27,500


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Transaction 9

Transaction 9: Payment of Expense. Ace pays $400salaries to legal assistant.

The transaction results in a decrease to Cash Asset and adecrease to Equity because of salaries expense.


Cash + Accounts Receivable + Supplies + Equipment

on Hand

Accounts

Payable

Capital

Old bal. $15,000 + $2,000 + $1,500 + $9,000 = $6,000 + $21,500

Trans 9: - $400 - $400

New bal. $14,600 + $2,000 + $1,500 + $9,000 = $6,000 + $21,100

Total: $27,100 = $27,100


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Transaction 10

Transaction 10: It was determined that $500 of stationery supplies onhand has been used up.

The transaction results in a decrease to the Supplies on Hand Asset anda decrease to Equity as a result of supplies becoming used up.

We note that the equation has remained in balance,

i.e. A = L + OE

Assets = Liabilities

+ OwnersEquity


on Hand

Accounts

Payable

Capital

Old bal. $14,600 + $2,000 + $1,500 + $9,000 = $6,000 + $21,100

Trans 10: - $500 - $500

New bal. $14,600 + $2,000 + $1,000 + $9,000 = $6,000 + $20,600

Total: $26,600 = $26,600


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Expanded accounting equation

The accounting equation can be expanded toinclude Revenue and Expenses.

We begin with:

Assets = Liabilities + Equity

We bring in the profit element:

Assets = Liabilities + Equity + Profit

Note: Profit = Revenue (Income) Expenses

Expanded we have:Assets = Liabilities + Equity + Revenue (Income) Expenses

Which can also be written as:

Assets + Expenses = Liabilities + Equity + Revenue (Income)


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Accounting Equation Analysis

Well, you have done it! The Waikato Legal Services illustration using the

accounting equation has shown you how to do thefollowing in the accounting process:

Analyse transactions by identifying the accounts itseffects on the main financial elements (Assets,Liabilities, Equity, Revenue (Income) and Expenses) offinancial statements

Showing the effects in the accounting equation and

maintaining the equation in balance all the time. This is the initial basis of understanding the double entry

system without actually learning the debit and credit rules of thedouble entry system. This comes next if you truly want tounderstand the accounting system of any organisation.

Accounting Equation Service Business 6

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