CHAPTER 2

The Accounting Equation

 THE ACCOUNTING EQUATION
Topic list
1 • Assets, liabilities and the business entity concept

2 • The accounting equation

3 • Credit transactions

4 • The statement of financial position

5 • Preparing the statement of financial position

6 • The statement of profit or loss

Some definitions

• is a resource controlled by the entity as a result of past events

Asset and from which future economic benefits are expected to flow to
the entity.

• is a present obligation of the entity arising from past events,

A liability the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits.

• is the residual interest in the assets of the entity after

Equity deducting all its liabilities. Equity is also the amount invested in
a business by the owners.
Some definitions

The future economic benefit embodied in an asset is the potential to contribute,

directly or indirectly, to the flow of cash and cash equivalents to the entity.

The future economic benefits embodied in an asset may flow to the entity in a
number of ways.

• An asset may be:

• used singly or in combination with other assets in the production of goods or
services to be sold by the entity;
• exchanged for other assets;
• used to settle a liability; or
• distributed to the owners of the entity.
Some definitions
The settlement of a present obligation usually involves the entity giving up resources embodying
economic benefits in order to satisfy the claim of the other party.

Settlement of a present obligation may occur in a number of ways, for example, by:

• payment of cash;

• transfer of other assets;

• provision of services;

• replacement of that obligation with another obligation; or

• conversion of the obligation to equity.

Some definitions

• Land & buildings • Bank loan or overdraft

• Motor Vehicles • Payables (creditors)
• Plant & Machinery • Taxation
• Fixtures & fitting
• Cash
• Inventory
• Receivables (debtors)
Some definitions

• is increases in economic benefits during the accounting period in the form

of inflows or enhancements of assets or decreases of liabilities that result in
Income increases in equity, other than those relating to contributions from equity
participants.

• arises in the course of the ordinary activities of an entity and is referred to

by a variety of different names including sales, fees, interest, dividends,
Revenue royalties and rent.

• represent other items that meet the definition of income and may, or may
not, arise in the course of the ordinary activities of an entity. Gains
Gains represent increases in economic benefits and as such are no different in
nature from revenue.
Some definitions

• are decreases in economic benefits during the accounting period in the form of
Expenses outflows or depletions of assets or incurrences of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants

The definition of expenses encompasses losses as well as those expenses that arise in the course of
the ordinary activities of the entity

• represent other items that meet the definition of expenses and may, or may not, arise in the
course of the ordinary activities of the entity. Losses represent decreases in economic
Losses benefits and as such they are no different in nature from other expenses. Losses are often
reported net of related income.

• Dividends are the distribution of cash or other assets to stockholders.

Dividend • Dividends reduce retained earnings. However, dividends are not an expense
The business entity concept

The law There is no Accounting

recognises a legal any business is
company as a separation treated as a
legal entity, between a sole separate entity
quite separate trader and the from its owner
from its business -> business
owners he/she runs. entity concept
Accounting equation

TOTAL
CAPITAL LIABILITIES
ASSETS

Equity/ Capital = Capital introduced + Retained profits

Equity/ Capital = Capital introduced + ( t–

Profit/Loss = Revenue - Drawings are amounts of

Expenditure money taken out of a business
by its owners
Accounting equation

TOTAL
NET ASSETS TOTAL ASSETS CAPITAL
LIABILITIES

ASSET CAPITAL LIABILITIES DRAWINGS PFOFIT

Drawing

The owner of a sole trader ship does not get paid a wage; they “draw out” or appropriate some of
their capital as drawings.
Drawings: Money and goods taken out of a business by its owner
Double entry

Double entry bookkeeping is based on the idea that each transaction has an equal but opposite effect.
Every accounting event must be entered in ledger account both as debit and as credit. Every transaction
has two effects dual effect

You own car worth

$10,000
purchase car for $10,000
cash

Your cash less

$10,000
Double entry
You own car worth
$10,000
borrow bank for purchase
car
You owe bank
$10,000

You have $500 cash less

If you pay $500 for repair

car
You incurred repair
expense of $500
Double entry
Double entry bookkeeping: Method recording financial transaction
Account is maintained for every supplier, customer, asset, income, expenses
Every transaction recorded twice so every debit is balanced by a credit.

Rule of Double Entry (Dual effect or Duality Concept)

Debit
Assets/Expenses

Credit

Credit

Liabilities/Capitals/Income
Debit
Remember
EXPENSES have same direction with ASSET
INCOMES/REVENUES have same direction with LIABILITY/CAPITAL

DEBIT CREDIT
To own/have To owe
An asset increase An asset decrease
Capital/liability decrease Capital/liability increase
Income decrease Income increase
An expense increase An expense decrease
Left hand side Right hand side
Remember

Investments by stockholders represent the total amount paid in by

stockholders for the shares they purchase.
Credit transaction – Trade payables

Person to whom a business owes

Creditor •
money.

A trade creditor • is a person to whom a business owes

money for trading debts

Trade payables • The amounts due to credit suppliers.

Credit transaction – Trade payables

How would each of these transactions affect the accounting equation in

terms of increase or decrease in asset, capital or liability?

(a) Purchasing £800 worth of goods on credit

(b) Paying the telephone bill £25
(c) Selling goods for £650
(d) Paying £800 to a supplier
Credit transaction – Trade receivables

Debtor • Person who owes money to the business

Trade receivables • The amounts owed by credit customers

The statement of financial position

Shows its Reports the assets, liabilities, and stockholders’ equity at a specific date

financial
position Lists assets at the top, followed by liabilities and capital.
at a
given Total assets must equal total liabilities and capital
moment
in time
It is a snapshot of the company’s financial condition at a specific
moment in time (usually the month-end or year-end).
The statement of financial position - Assets
• Current Asset: are expected to be • Non-current asset: are acquired for
converted into cash within one year long-term use within the business

• Cash • Property, plant and equipment

• Items owned by the business with the (tangible assets – PPE)
intention of turning them into cash in • Intangible non-current assets
a short time:
• Long-term investments
⮚ Inventory
⮚ Trade and other receivables
⮚ Short-term investments

⮚ Prepayments (prepaid
expenses)
 The statement of financial position - NCA and depreciation

Non-current assets are held and used by a business

for a number of years, but they wear out or lose

their usefulness in the course of time.

Every tangible non-current asset has a limited life.

The only exception is freehold land.

The statement of financial position
Interactive question 4: Asset classification
Identify which of the following assets falls into the non-current category and which
should be treated as current.
Could any be treated as either?
The statement of financial position - Liabilities

• Current liabilities: are debts which • Non-current liabilities: are debts

are payable within one year
• Loans: repayable within one year,
including element of a long term
loan that is repayable within one
year
• Bank overdraft (repayable on
demand)
• Trade payable
• Taxation payables
• Accruals, other payables,…
which are payable after one year
• Loans: not repayable for more than
one year, ie. bank loan, loan from
individual or business
• Loan stock or debentures (limited
company)
The statement of financial position – Capital
Capital (sole trader)
The sole trader's capital is usually analysed into its component parts.
'Brought forward' means that the amount is brought forward from the previous period. Similarly, 'carried
forward' means carried forward to the next period.
£ £
Capital at the beginning of the reporting period
(ie capital brought forward) X
Add additional capital introduced during the period X
X
Add profit earned during the period (or less losses incurred in the period) X
Less drawings (X)
Retained profit for the period X
Capital as at the end of the reporting period (ie capital carried forward) X
 Preparing the statement of financial statement

Step 1 • Gather the needed information

Step 2 • Prepare the heading

Step 3 • Report all company assets

Step 4 • Report all liabilities

Step 5 • Report the ending balance of capital after total liabilities

Preparing the statement of financial statement
Prepare a statement of financial position for Sunken Arches as at 31 December 20X6, given the information
below.
£
Capital as at 1 January 20X6 51,100
Profit for the year to 31 December 20X6 8,000
Premises, carrying amount at 31 December 20X6 50,000
Motor vehicles, carrying amount at 31 December 20X6 9,000
Fixtures and fittings, carrying amount at 31 December 20X6 8,000
Non-current loan 25,000
Bank overdraft * 2,000
Inventories 16,000
Trade receivables 500
Cash in hand * 100
Trade payables 1,200
Drawings 4,000
Accrued costs of rent 600
Prepayment of insurance premium 300
* A shop might have cash in its cash registers, but an overdraft at the bank.
Preparing the statement of financial statement
Sunken Arches
Statement of financial position as at 31 December 20X6
£ £
ASSETS
Non-current assets
Property, plant and equipment
Premises 50,000
Fixtures and fittings 8,000
Motor vehicles 9,000
Current assets 67,000
Inventories 16,000
Trade and other receivables 500
Prepayments 300
Cash and cash equivalents 100
16,900
Total assets 83,900
Preparing the statement of financial statement

CAPITAL AND LIABILITIES

Capital
As at 1 January 20X6 51,100
Profit for the year 8,000
Less drawings (4,000)
At 31 December 20X6 55,100
Non-current liabilities
Long-term borrowings 25,000
Current liabilities
Short-term borrowings (bank overdraft) 2,000
Trade and other payables 1,200
Accrued costs 600
3,800
Total capital and liabilities 83,900
 Statement of Profit or Loss
• Is a statement in which two key elements of financial statements – income and expenses – are
matched to arrive at profit or loss

• Many businesses distinguish between:

• Gross Profit earned on trading (revenue – cost of sales)

• Profit for the year (Net Profit/Net Income) after other income and expenses
Statement of Profit or Loss/Income Statement

Reports the profitability of the company’s

operations over a specific period of time.

Lists revenues first, followed by expenses.

Shows net income (or net loss).

Profit and loss statement
Gross Profit XXXX
Plus any other income from source other than the sale of goods X

Minus other business expenses, not included in the cost of good sold (XX)
XXX

Income from other sources: Business expense, other than COS:

- Profit on disposals of non-current assets
- Dividends or interest received from investments
- Rental income from property owned but not
otherwise used by the business
- Amounts due in respect of insurance claims
- Cash Discounts received
- Distribution costs/selling expense: salaries, wages,
commission of employees; marketing costs,
depreciation
- Administrative costs/expense: management &
office staff salaries, rent, insurance, telephone and
postage, …
- Finance costs/financial expense: interest on loans,
bank overdraft interest
Relationship between the statement of profit or loss and the statement of
financial position

1. Net profit is the profit for

the period. A net loss
would be transferred as a
deduction from capital in
the statement of financial 2. Drawings are appropriations of
position. profit and not expenses.
 Relationship
between the
statement of
profit or loss and
the statement of
financial position
Relationship between Fs Cash Flow Statement
Cash from operations
Cash from investing
Cash from financing
______________________
Beginning SOFP Ending SOFP
Change in cash

Cash Statement of changing equity Cash

+ Other Assets + Other Assets
Investment and disinvestment by owners
___________________ ___________________
Net income and other earnings
Total Assets Total Assets
______________________
- Liabilities - Liabilities
Net change in owners’ equity
___________________ ___________________
Owners’ rquity Owners’ rquity
PL and OCI
Revenues
Expenses
______________________
Net income
 Multiple choice questions

1. Which of the following is an asset?

A. A trade payable

B. A loan

C. Drawings

D. A prepayment
 Multiple choice questions

2. Which of the following is a liability?

A. Depreciation

B. An accrual

C. Cash at bank

D. Plant and machinery

 Multiple choice questions

3. Capital is the amount:

A. The entity's owners owe to it

B. The entity's customers owe to it

C. The entity owes to its creditors

D. The entity 'owes' to its owners

 Multiple choice questions

4. Which of the following are assets of an entity?

A. Trade payables

B. Trade receivables

C. Bank overdraft

D. Cash in hand

E. Funds introduced by the owner

 Multiple choice questions

5. Which of the following best describes the

accruals concept?

A. Assets are matched with liabilities

B. Income is matched with expenses

C. Expenses are matched with assets

D. Income is matched with liabilities

 Multiple choice questions

6. Which of the following is a non-current

liability?

A. Bank overdraft

B. Bank loan repayable within a year

C. A mortgage repayable within 5 years

D. Trade payable
 Multiple choice questions

7. The statement of financial position sets out

the entity’s:

A. Financial position over a period of time

B. Financial performance over a period of time

C. Financial position at one point in time

D. Financial performance at one point in time

 Multiple choice questions

8. Which of the following expenses is included in

cost of sales?

A. Sales people's salaries

B. Management salaries

C. Overdraft

D. Cost of raw material

 Multiple choice questions

9. A business has sales of £100,000, cost of sales

of £60,000 and expenses of £20,000. The gross
profit margin is:
A. 60%
B. 40%
C. 20%
D. 80%
 Multiple choice questions

10. Which figure from a sole trader's statement

of profit or loss would appear in its statement of
financial position?
A. Gross profit
B. Drawings
C. Revenue
D. Net profit