Business Accounting 1

THE ACCOUNTING EQUATION

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 Introduction
• Business entity concept – owner and the business are
separate entities
• Accounts are prepared based on the view point of the
business
• The accounting equation shows the relationship
between assets, liabilities and owner’s equity (or
capital).

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 Introduction
• At the start:
Resources owned by the business = Resources supplied
by the owner
i.e; Assets = Capital

Normally, business will borrow monies or purchase on

credit term.
Hence, Assets = Capital + Liabilities

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 Assets
• Assets are possessions of value owned by a business
because they bring future benefits to the business
entity.
• They are acquired for a business to carry out its day-
to-day activities.
• Examples: debtors, cash in hand, office equipment,
stock.

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Assets

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 Assets
• Non-current assets are assets that are expected to be
used for more than one accounting year from the
balance sheet date.
• They include fixed assets, intangible assets and long-
term investments.
• Fixed assets
– are acquired to help in the running of the business.
– not for resale
– permanent in nature and can be used for more
than one accounting year
– Examples: premises, machinery, motor vehicles,
office equipment, fittings and fixtures and 6
furniture.
 Assets
• Intangible assets
– no physical existence
– Examples: trademarks, copyrights and patents.
• Long-term investments
– comprise investments in shares and securities
which are held by the business for more than one
accounting year to earn dividends or interest and
are not for resale.

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 Assets
• Current assets are assets that can be converted into
cash easily or will be consumed within an accounting
year from the balance sheet date.

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 Assets

• Convertibility of Assets
• The above figure shows that cash is converted into stock
when goods are bought, stock is converted into cash
when it is sold for cash and the amount owed by
debtors is converted into cash when debts are settled.
This process of buying goods until cash is received from
the resale of the goods is called the operating cycle.
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 Assets
• Examples of current assets: cash in hand, cash at
bank, debtors, stock and prepayments (or expenses
paid before they are incurred).
• In determining whether an item is a fixed asset or
current asset, one should not just look at the item
but also the nature of the business. For example, a
computer is a fixed asset to an accounting firm but a
current asset, stock, to a firm selling computers.

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 Liabilities
• Liabilities are amounts owed by the business to
outside parties.
• Examples: creditors, loans and outstanding expenses.
• Liabilities are business obligations that represent the
claims by the external parties against the business
assets.
• In the event of non-payment, creditors can force the
business to liquidate and be paid the amounts due to
them before any claims by the owners.

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 Liabilities

• Long-term liabilities are the amounts owed and which

the business has more than one accounting year from
the balance sheet date to settle. Examples : bank
loans, mortgages and debentures.

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 Liabilities
• Current liabilities are the amounts owed by the
business that have to be settled within an accounting
year from the balance sheet date.
• Examples : bank overdraft, creditors and accrued
expenses (expenses incurred but not paid yet,
sometimes also called outstanding expenses).

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 Owner’s Equity
• Owner’s equity or capital is the investment made by
the owner, plus the undistributed profit.
• It represents the owner’s interest in the business.
• Owner’s equity is what the business owes to the
owner.
• Owner’s Equity / Capital = Assets – Liabilities

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 Owner’s Equity
• Drawings will reduce the owner’s equity.
• Drawings refer to the withdrawal of assets for
personal use.
• For a sole proprietorship, capital is contributed by
the owner.
• For a partnership business, capital is contributed by
the partners.
• For limited companies, capital is contributed by
shareholders through the issue of shares to the
investors.

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 The Accounting Equation
• Definition

• Accounting equation shows the financial position of

a business entity at a particular date (ie how much
the business owns and owes, and the owner’s
interest in the business).
• That particular date is called balance sheet date.

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 The Accounting Equation
• Example

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The Accounting Equation

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 Balance Sheet
• The Balance Sheet or Statement of Financial Position
is a financial report that shows the financial position
of a business at a particular date.
• It shows the value of the assets, liabilities and
owner’s equity at the balance sheet date.
• It is actually an expression of the accounting
equation in a more detailed and organized form.

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 Effects of Transactions on the
Accounting Equation
• A business transaction involves an exchange in which
the parties involved receive and give value
• e.g. purchases or sales of goods and services.
• Each transaction must have at least two effects on
the accounting equation.
• Regardless of the types of transactions, the equality
of the accounting equation is always maintained.

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Effects of Transactions on the
Accounting Equation

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Effects of Transactions on the
Accounting Equation

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Effects of Transactions on the
Accounting Equation

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Effects of Transactions on the
Accounting Equation

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Effects of Transactions on the
Accounting Equation

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Effects of Transactions on the
Accounting Equation

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Effects of Transactions on the
Accounting Equation
Statement of Financial Position as at XXXX
Non-current assets $
Furniture 5,000
Vehicles 15,000
20,000
Current assets
Cash 42,500
Total assets 62,500

Equity
Capital 50,500

Non-current liabilities
Loan 11,000

Current liabilities
Creditors 1,000
Total Equity and Liabilities 62,500 27
The Expanded Accounting Equation
Revenue
• Revenue is the money received or will be received in
future by the business arising from the goods sold
and services rendered.
• Capital contribution of the owner or loans made to
the entity is Not revenue.
• Revenues increase assets and/or decrease liability.
• Examples: sale of goods, service fees received, rent
received, commission received, interest received.

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The Expanded Accounting Equation
Expenses
• Expenses are money or other assets that a business
uses up (or consumed) as a result of the business
activities.
• Expenses are incurred when a business receives
services or purchases goods.
• Expenses decrease assets and/or increase liabilities.
• Examples: purchase of goods for resale, insurance,
wages, carriage inwards, carriage outwards, rent
paid, interest paid.

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 Capital Expenditure (Capex)
Capital expenditure refers to business spending
either to:

• acquire new non-current assets such as machinery, office

equipment and vehicles
or
• improve the value of an existing non-current asset

Capital expenditure can bring economic benefits (i.e.

useful) to the company beyond the current accounting
period.

It is recorded as an asset into account when spent and is

shown as non-current asset in the Balance Sheet .
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 Revenue Expenditure
• Revenue expenditure refers to spending on
operating a company’s business to generate
revenue.
• It is necessary to ‘run’ the business on a day-to-
day basis and thus, is also called as running
expenses.
• This spending is used up during the current
accounting period. It does not bring economic
benefits to the company beyond the current
accounting period.
• It is charged out to the Profit and Loss a/c as an
expense in the current accounting period when
spent. 31
The Expanded Accounting Equation
Relationship between Revenues and Expenses
• The relationship between revenues and expenses
can be measured in terms of profits and losses.

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The Expanded Accounting Equation
Income Statement (or Statement of Profit or Loss)
• The income statement is a financial report that
shows the income earned and the expenses incurred
by an entity for an accounting period.
• It shows the relationship between revenues and
expenses.
• This statement reflects the business performance for
a particular period.

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The Expanded Accounting Equation
Relationship between Revenues, Expenses and Owner’s
Equity
• A positive relationship exists between revenues and
owner’s equity. Revenue increases the net assets of a
business entity.
• A negative relationship exists between expenses and
owner’s equity. Expenses use up the net assets of a
business entity.
• Profits (Revenue > Expenses) increase owner’s equity.
• Losses (Revenue < Expenses) decrease owner’s equity.

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The Expanded Accounting Equation
Balance Sheet Income Statement

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Effects of Transactions on the Expanded
Accounting Equation

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Effects of Transactions on the Expanded
Accounting Equation

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Effects of Transactions on the Expanded
Accounting Equation

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Effects of Transactions on the Expanded
Accounting Equation

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Effects of Transactions on the Expanded
Accounting Equation
Statement of Profit or Loss for the month / year ended XXXX
$ $
Revenue 500

Add: Other income 20

Discount received

Less: Expenses
Wages 300
Discount allowed 80 (380)

Net profit 140

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 Effects of Transactions on the Expanded
Accounting Equation
Statement of Financial Position as at XXXX (Old) Statement of Financial Position as at XXXX (New)
Non-current assets $ Non-current assets $
Vehicles 15,000 Vehicles 15,000

Current assets Current assets

Cash 5,000 Cash 5,600
Debtors 8,000 Debtors 7,120
13,000 12,720
Total assets 28,000 Total assets 27,720

Equity
Equity
Capital 17,000
Capital 17,000
Net profit 140
17,140
Non-current liabilities
Non-current liabilities
Loan 10,000
Loan 10,000

Current liabilities Current liabilities

Creditors 1,000 Creditors 580
Total Equity and Liabilities 28,000 Total Equity and Liabilities 27,720
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 THE ACCOUNTING EQUATION
• Resources supplied by the owners = Resources
in the business
•

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