The Accounting Equation

 Quick recap:
 4 features of accounting:
 entity;
 economic events;
 financial description;
 end users

 Look at:
 Defining elements
 Recognition and disclosure
 Accounting equation

 Relevant ILOs:
 1. Describe and apply key financial accounting terms,
concepts and ideas
 2. Construct bookkeeping records, including a trial balance,
from the accounting records;
Pauline Weetman, Financial and Management Accounting, 5th Edition @ Pearson Education Limited 2010 1
Some definitions
 Before looking at the accounting equation, need to
understand the elements of accounting:

ts
Asse

b i l i ties p
Lia e r s hi
Own est
r
Inte

 Define these terms and identify when transactions are

recorded
Pauline in our
Weetman, Financial financial
and Management statements.
Accounting, 5th Edition @ Pearson Education Limited 2010 2
Definition of an asset:
Asset: A resource

• _________________ by the entity

• As a result of ___________ events
• And from which future economic
benefits are expected to flow to the
entity.

• Per IASB Framework para 4.4

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Examples of assets:
Land and buildings

Raw materials

More examples in chapter 2

Non-
Current
current
assets
assets 4
Recognition (Per IASB Framework para 4.38)

Recognised as an asset? (i. e. reported in the

balance sheet)?
 Only if- It is _____________
that the future
economic benefits
associated with the
item will flow to the
entity

and the item has a cost

or value that can be
measured with
_________________. 5
Class Example - Recognise or not?
 Should the following items be recognised as an
asset? Why? (Look back at the recognition criteria.)

 Land and buildings owned by a business

 Raw materials owned by the business

 Workforce employed by the business

 Major advertising campaign undertaken by the business.

Pauline Weetman, Financial and Management Accounting, 5th Edition @ Pearson Education Limited 2010 6
Definition of a liability:

Liability:

• A present ________________
• arising from _______________ events,
• the settlement of which is expected to
result in an outflow from the entity of
resources embodying economic benefits.

• Per IASB Framework para 4.4

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Recognition (Per IASB Framework para 4.38)

Recognised as a liability? (i. e. reported in the

balance sheet)?
 Only if-
It is probable that
any future economic
benefit associated
with the item will
flow from the entity

and the item has a

cost or value that
can be measured
with reliability. 8
Examples of liabilities:
Bank borrowing e.g. loans and overdraft

Taxation payable

Trade payables (due to suppliers for goods on credit)

More examples in chapter 2

Contingent liabilities (additional category)

Non-
Current
current
liabilities
liabilities
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Ownership interest/equity:
• Equity is the residual interest in the assets of the entity after
deducting all its liabilities. (para 4.4)

• The term __________________________is used as a

shorter way of saying 'total assets less total liabilities'.

• Recognition totally dependent on the recognition of assets

and liabilities.

• Changes in equity result when assets and liabilities

increase and decrease. This can be a result of:

• Owners putting more money into the business

• Owners withdrawing money
• Profits or losses being generated
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Revenue and expenses
 Other elements of financial statements (usually recorded
in the income statement) are revenue and expenses.

 Revenue: increase in ownership interest (i.e. increase in

net assets – such as cash) e.g. sales, rent

 Expenses: decrease in ownership interest (i e decrease

in net assets – e.g. by spending cash on wages or
incurring a new liability)

Formal definitions in IASB Conceptual Framework

paragraph 4.25
Pauline Weetman, Financial and Management Accounting, 5th Edition @ Pearson Education Limited 2010 11
Statement of financial position
accounting equation

Ownership
______ ________
Interest

12
Alternative equation format
Ownership
Assets Liabilities
Interest

A = L + OI

Format depends on particular country’s preference, but all

information is the same – just in a different order.

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Statement of Financial Position
follows this equation

Assets

Liabilities

Ownership
Interest
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Income Statement Accounting
Equation

_________ ________ Profit/loss

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Linking the equations
Developing the equations further allows us to
link them together.
Currently have:

Ownership
Assets Liabilities
Interest

and

Revenue Expenses Profit/loss

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What causes changes in OI
(Equity)?
 Owner ____________ resources to the business
(Invest cash in the business)
 or
 Owner ______________ resources from the
business (withdraw cash from the business)
 or
 ______________ generates profits (or losses)
which belong to the owners
 So profits/losses are part of equity – linking the 2
equations
Pauline Weetman, Financial and Management Accounting, 5th Edition @ Pearson Education Limited 2010 17
Some final terminology
 We have developed our equations
Assets – Liabilities = Ownership Interest
and
Revenue – Expenses = Profit/Loss

 Now think about recording issues and double

entry bookkeeping.
 New terminology – debits and credits.
 Duality of transactions.

Pauline Weetman, Financial and Management Accounting, 5th Edition @ Pearson Education Limited 2010 18
Duality of transactions

 Every transaction has 2 aspects – an inflow &

outflow. (Need to keep our equations in
balance.)

 Examples:
 We buy a loaf of bread for £1 (inflow = loaf of bread,
outflow = £1 cash)
 We sell Mission Impossible DVD for £10. (inflow =
£10 cash, outflow = DVD)

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Debits and credits
 Recognise inflows and outflows using the terms
debits and credits to show increases or
decreases in elements of the financial
statements.

 Duality of transactions means there must be a

debit and credit for every transaction.

 TOTAL ___________ = TOTAL ____________

Pauline Weetman, Financial and Management Accounting, 5th Edition @ Pearson Education Limited 2010 20
Effect of debits and credits
DEBIT CREDIT
ENTRIES ENTRIES

Asset = debit Increase Decrease

Liability = credit Decrease Increase

Ownership Expense Revenue
interest = credit
Capital Capital
withdrawn contributed
Pauline Weetman, Financial and Management Accounting, 5th Edition @ Pearson Education Limited 2010 21
Debits and Credits and the effect on
the accounting equations
TOTAL DEBITS = TOTAL CREDITS

 Then from previous table:

Assets + Expenses = Liabilities + Revenue
+Capital Withdrawn + Capital Introduced

A + E + CW = L + R + CI

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Class Example – washing machine
sales
For the following transactions, identify the
debit and credit item and show the equation
is still in balance:

1. On 1 January, owner puts £2,000 in to the

business.
2. On 4 February buy 5 washing machines for
£1,000 and promise to pay for them on 31
March.
3. On 31 March you pay for the washing machines.

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Conclusion
 From the example we have seen:

 ____________ of transactions
 TOTAL DEBITS = TOTAL CREDITS
 Need more detailed information on what is included in
each category e.g. assets
 Need to develop detailed ____________ systems

Pauline Weetman, Financial and Management Accounting, 5th Edition @ Pearson Education Limited 2010 24