Lecture 2

Accounting Principles 1
 Chapter Two
The Accounting Equation
and The Debit and Credit
Rule
 • The financial statements are reports prepared by
accountants as the final product of the
accounting system. The most widely used
statements are the income statement and the
The statement of financial position.
Financial • The Statement of Financial Position.
Statements • The statement of financial position shows
resources owned or controlled by the firm and its
Obligations to others. The difference between
resources owned (assets) and obligations
(Liabilities) is called Owner's equity or Capital.
The statement of financial position includes:
 1. Assets:
Assets are expected economic benefits owned or
controlled by the entity as a result of past
The transactions.

Statement Assets are characterized with:

- Having expected future benefits.
of - Owned or controlled by the entity. No other entity
Financial can reach or use them without permission from the
entity.
Position. - The transactions or events led to get these benefits
actually occurred.
• Assets include Cash, Land, Buildings, Equipment,
Inventory, Accounts Receivable, Notes Receivable,
Copyrights, and franchising.
 2. Liabilities (Obligations)
Liabilities Are future economic sacrifices of benefits resulting

The
from current obligations to transfer or render services to other
entities in the future as a result of past transactions or events.
Statement Liabilities have the following characteristics:
- Include a responsibility or current claim to another entity,
of which will be met by the use or transfer of assets at a certain
Financial future time.
- This liability or claim cannot be avoided or escaped.
Position. - The transaction or events that caused this liability has
actually occurred.
• Liabilities include Accounts payable, Notes payable,
Expenses payable, unearned revenues, bonds payable, and
short and long-term loans payable, etc.
 3. Owner's Equity or Capital
Is the remaining of assets after subtracting all liabilities.
The statement of financial position can be shown in two
different forms as follows:
The
XXX Company
Statement Statement of Financial Position

of Cash
31/1 2/xxx
$12,000 Accounts payable $4,000

Financial Accounts Receivable

Inventory
5,000 Notes payable
15,000 L T. Liabilities
1,000
10,000

Position. Land
Buildings
20,000 Total Liabilities
50,000 Owner's equity
15,000
87,000

Total Assets $102,000 Total Liabilities & Equity $102,000

 Or the statement of financial position can be presented as
a report as follows:
XXX Company
Statement of Financial Position
The Assets
31/1 2/xxx

Statement Cash
Accounts Receivable
$12,000
5,000
of Inventory
Land
15,000
20,000
Financial Buildings
Total Assets
50,000
$102,000
Position. Liabilities & Owner's equity
Liabilities
Accounts payable $4,000
Notes payable 1,000
L T. Liabilities 10,000
Total Liabilities 15,000
Owner's equity 87,000
Total Liabilities & Owner's Equity $102,000
 Presenting assets and liabilities on the statement of financial
position is based on a set of assumptions and principles which
Accounting can be summarised as follows:

assumptions
1. Accounting Entity Assumptions:
According to this assumption, the business is viewed or a part of
and it or its activities separate from the personal activities of owners.
This statement contains any elements related only to business.
Principles This is because mixing personal activities with business activities
leads to the inability of describing and measuring business
Related to activities alone. Separating personal activities from business
the activities requires professional judgment of accountants.
2. The Going Concern Assumption
statement According to this assumption, the statement of financial position
of financial is prepared with the assumption that the entity or company will
continue in business until it achieves its goals. Accordingly, any
position. change in the prices of assets after acquisition is not important
since the objective of acquisition is using them in activities and
operations not to resell them. Sale of assets may result in ending
business or affect the continuity of the firm
 3. The Cost Principle:
According to the cost principle, assets and liabilities are shown
on the statement of financial position at their cost. Any
Accounting changes in the value of assets after the acquisition is ignored.
This means that the values of assets do not reflect the market
assumptions values of these assets.
and 4. Stable Monetary Unit Assumption:

Principles Values are measured using known currencies (Dollar, Euro,

Egyptian pounds, etc.) Because these currencies are generally
Related to accepted measure of value and a medium of exchange. It is
also assumed that the monetary unit has fixed purchasing
the power.
statement This assumption can be accepted in stable economic
conditions but is not accepted in periods of inflation and rising
of financial prices. the purchasing power declines. In cases of deflation,
the purchasing power increases. Many counties solved this
position. problem using monetary units with constant purchasing power
using historical cost adjusted by index numbers, Current cost
replacement cost, or fair value to measure the values of assets
and liabilities on the statement of financial position.
 The previous discussion showed that the assets side of the
statement of financial position equals the sum of liabilities
and owner's equity side. This balancing helps in analyzing
the effect of different business activities on assets,

The liabilities, and owner’s equity. Accordingly, the relationship

between assets, liabilities, and owner’s equity in the form of
Accounting an equation called the accounting equation or the balance
sheet equation as follows:
Equation. | Assets = Liabilities + Owner’s equity |
This means that the assets of the firm (Economic
resources) are financed using funds obtained from
creditors or owners. This equation can be restructured as
follows:
| Owner’s equity = Assets - Liabilities |
 Example:
The following transactions took place in Ahmed Company:
• Deposit cash in the bank as owner's capital.
Analysis of 1. Ahmed deposits $50,000 in the bank as capital.
• The assets increased by 50,000, owner's equity increased
the effects of by 50,000. The accounting equation remained balanced.
business This can be shown as follows:
transactions Assets = Liabilities + Owner’s equity
on the Cash Ahmed's Capital
Deposit cash +50,000 +50,000
accounting Total 50,000 50,000
equation:
 • Getting a Loan from a bank
2. Assume that Ahmed goes to the bank to get extra
cash as a loan. The bank agreed to give him a loan
for $25,000 in cash. This transaction increases
Analysis of cash and Loan Payable by $25,000 each. So, each
the effects of side of the equation increases by $25,000. The
business equation remains balanced after this transaction.
transactions Assets = Liabilities + Owner’s equity
on the Cash Loan Payable Ahmed's Capital
accounting Deposit cash 50,000 50,000

equation: Loan from bank

Total
+25,000
75,000
+25,000
25,000 50,000
 • Purchase Assets in cash
3. Assume that Ahmed purchased a small office
building for his business for $30,000 in cash. Cash
will be decreased by $30,000. At the same time
Analysis of assets Buildings increased by $30,000. The
the effects of equation remained balanced.
business
Assets = Liabilities + Owner’s equity
transactions Cash Buildings Loan Payable Ahmed's Capital
on the Deposit cash 50,000 50,000

accounting Loan from bank

Purchase
25,000
of -30.000 +30,000
25,000

equation: buildings
Total 45,000 30,000 25,000 50,000
 • Purchase Assets on credit
4. Assume that Ahmed purchased equipment on credit. The
amount due may be paid later on an open account or Ahmed
may sign a legal promise to pay the amount due at a certain
future date.
Analysis of • Suppose Ahmed purchased a computer on credit for
the effects of $5,000. The result increase assets by $5,000 and Accounts
business Payable (A/P) $5,000. The equation remains balanced as
follows:
transactions Assets = Liabilities + Owner’s
on the Cash Buildings Computers Loan A/P
equity
Ahmed's
accounting Deposit cash 50,000
Payable Capital
50,000
equation: Loan from
bank
25,000 25,000

Purchase of 30.000 30,000

buildings
Purchase of +5,000 +5,000
computers
Total 45,000 30,000 5,000 25,000 5,000 50,000
 • Purchase of assets with partial cash payment
The company may want to use the credit limits provided by suppliers of
assets. So, it pays part of the price in cash and part on credit to be paid
later. Assets will increase by the full price; cash will decrease with the
amount of payment and accounts payable (or notes payable) will
Analysis of increase by the amount still not paid.
5. Ahmed purchased office supplies for $3,000, paid $1,000 in cash and
the effects of signed a note payable for the remaining amount to be paid after one
business month. Office supplies increases by $3,000, cash decreases by $1,000
and notes payable increases by $2,000. The equation will be in balance
transactions after this transaction as follows:
on the
Assets = Liabilities +
Owner’s

accounting Cash Building Computers supplies L/ P A/P N/P

equity
Ahmed's

equation: Previous 45,000 30,000 5,000 25,000 5,000

Capital
50,000
transactions
Purchase of -1000 + 3000 +2000
supplies
Total 44,000 30,000 5,000 3000 25,000 5,000 2000 50,000
 • Sale of some assets at cost in cash:
The company may decide to dispose of some of its assets for cash at cost
(i.e. without any profit).
6. If the company sold half of the building for $15,000 in cash, building
is decreased by $15,000, cash increases by $15,000. The accounting
Analysis of equation remains balanced. The effect of this transaction on the

the effects of accounting equation will be as follows:

business
Assets = Liabilities +
Owner’s

transactions Cash Building Computers supplies L/ P A/P N/P

equity
Ahmed's

on the Previous 44,000

s
30,000 5,000 3000 25,000 5,000 2000
Capital
50,000
accounting transactions

equation: Sale of part +15,00

of building 0
-15,000

Total 59,000 15,000 5,000 3000 25,000 5,000 2000 50,000

 • Sale of assets at cost on credit:
The company may sell the asset, but the buyer will pay the amount later.
7. If the company sold the computers on credit instead of cash. The
buyer will pay the amount due within one month. This transaction will
not affect cash. A new asset will be created. The buyer owes the company
Analysis of $5,000, that should be paid within one month. This is called Account
Receivable (A/R). The final effect of this will be increase of accounts
the effects of receivable by $5,000 and decrease of computers by $5,000. The equation
business remains balanced as follows:
Assets = Liabilities +
transactions Owner’s
equity
on the Cash Buildings Computers supplies A/R L/ P A/P N/P Ahmed's
Capital

accounting Previous
transaction
59,000 15,000 5,000 3000 25,000 5,000 2000 50,000

equation: Sale
s
of -5,000 +5,000
computers
on account
Total 59,000 15,000 0 3000 5,000 25,000 5,000 2000 50,000
 • Repayment of part of the loan in cash
8. The company may decide to repay $10,000 of the loan to reduce its
liabilities. The effect of this transaction is to reduce Loans Payable by
$10,000 and decrease cash by $10,000. The accounting equation

Analysis of remains balanced as follows:

the effects of Assets = Liabilities +

Owner’s

business Cash Buildings Computer supplies A/R L/ P A/P N/P

equity
Ahmed's

transactions Previous 59,000 15,000

s
0 3000 5,000 25,000 5,000 2000
Capital
50,000

on the transactio
ns

accounting
Repaymen -10000 -10000
t part of

equation:
Loans
Total 49,000 15,000 0 3000 5,000 15,000 5,000 2000 50,000
 • Collecting Accounts Receivables:
The company may decide to collect the Accounts Receivable when due.
This will increase cash and reduce the Accounts Receivable.
9. Ahmed decides to collect $5,000 of the accounts receivable from
customers, Cash increases by $5,000 and AVR decreases by $15,000.
Analysis of The accounting equation remains balanced. The effect of this

the effects of transaction on the accounting equation will be as follows:

Assets = Liabilities +
business Owner’s
equity
transactions Cash Buildings Computer supplies
s
A/R L/ P A/P N/P Ahmed's
Capital

on the Previous
transactio
49,000 15,000 0 3000 5,000 15,000 5,000 2000 50,000

accounting ns
Collecting +5,000 -5,000

equation: A/R

Total 54,000 15,000 0 3000 0 15,000 5,000 2000 50,000

 • Increasing the owner's capital by additional investment
The owner may decide to increase his investments in the company to
meet the business expenses and needs. This requires that he deposits
additional cash in the bank. Cash increases and owner's equity (Capital)
increases. The accounting equation remains balanced.
Analysis of 10. Ahmed, deposits $20,000 in cash in the bank to increase his capital.

the effects of The effect of this transaction will be as follows:

Assets = Liabilities +
business Owner’s
equity
transactions Cash Buildings Computer supplies
s
A/R L/ P A/P N/P Ahmed's
Capital

on the Previous
transactio
54,000 15,000 0 3000 0 15,000 5,000 2000 50,000

accounting ns
Increasing +20,000 +20,000

equation: Capital

Total 74,000 15,000 0 3000 0 15,000 5,000 2000 70,000

 • Reducing owner’s capital in the company by withdrawal
The owner may decide to reduce his investment in the company by
withdrawing cash from the company or its bank. We should distinguish
between the withdrawal of cash with intention of reducing capital and
withdrawing cash from the bank to cover personal expenses. In the first

Analysis of
case, the owner intends to reduce his capital. In the second case, the
owner withdraws cash in anticipation of profit at the end of the year to
the effects of restore his capital.
11: Ahmed withdraws $10,000 to reduce his investment in the company.
business Cash is reduced by $10,000 and capital is reduced by $10,000. The
transactions accounting equation remains balanced. The effect of this transaction on
the accounting equation will be as follows:
on the Assets = Liabilities +
Owner’s
accounting Cash Buildings Computer supplies A/R L/ P A/P N/P
equity
Ahmed's
equation: Previous 74,000 15,000
s
0 3000 0 15,000 5,000 2000
Capital
70,000
transactio
ns
decreasing -10,000 -10,000
Capital

Total 64,000 15,000 0 3000 0 15,000 5,000 2000 60,000

 12: Ahmed draws $5,000 for his personal use. Cash is
reduced by $5,000, and the drawings account will increase
by $5,000 (if the drawings increase the capital will
decrease). The accounting equation remains balanced. The
Analysis of effect of this transaction on the accounting equation will be
as follows:
the effects of Assets = Liabilities +

business Owner’s
equity

transactions
Cash Buildings Computer supplies A/R L/ P A/P N/P Ahmed's
s Capital

on the
Previous 64,000 15,000 0 3000 0 15,000 5,000 2000 60,000
transactio

accounting
ns
Drawings -5,000 -5,000
for
equation: personal
use
Total 59,000 15,000 0 3000 0 15,000 5,000 2000 55,000
Thank you