Topic: The Accounting System and Accounting Equation – Lecture

Learning objectives
After you have studied this lecture, you should be able to:

• Explain accounting and book-keeping

• Describe and identify economic transactions

• Explain the accounting process

• Define source document and list some examples

• Describe the term books of original (prime) entry, list and explain the different types
• Present and explain the accounting equation

• Explain the meaning of the terms assets, capital, liabilities, accounts receivable (debtors) and
accounts payable (creditors)

• Describe how accounting transactions affect the items in the accounting equation
 Recap: What is accounting?

Accounting can be defined as:

The process of identifying, measuring and communicating

economic information
to permit informed judgements and
decisions by users of that information.
 What is book-keeping?

Book-keeping is the process of recording data relating to

accounting transactions in the accounting books.

Book-keeping looks at the recording of daily business

transactions.

Transaction is an event or activity that has a monetary

impact on business’ financial statement
Transactions and Events

Exchanges of economic consideration

(money) between two parties.
External Transactions
occur between the
organisation and an
outside party.

Internal Transactions
occur within the
organisation.
The Accounting Process

Source
Transaction documents Analysis
or event

Reporting
Trial balance Recording in books of
original entry & posting in
ledgers
Accounting Process
Source Documents –
Receipts & Invoice, Bank
Statement, Cheques

Journal – Cash book, General

Journal , Credit Sales Journal (sales
day book), Credit Purchases Journal
(purchases day book), Returns In &
Returns Out Journal
Ledger – General Ledger, Credit Sales Ledgers
(Sales ledger), Credit Purchases Ledgers
(Purchases ledger)

Balancing accounts and Extracting a Trial Balance (based on the

debit and credit balances )

Trading Profit and Loss Accounts (Income Statement), Balance Sheet (Statement of
Financial Position), Statement of Cash Flow, Statement of Changes in Equity
Steps in Processing Transactions

Assets = Liabilities + Equity

Step 2: Analyze
Step 1: Examine source transactions.
documents.

Equipment
30,000
GENERAL JOURNAL Page 123
Post.
Date Description Ref. Debit Credit

Bank
30,000
Step 3: Record
Step 5: Prepare a transactions in a
Step 4: Record the journal
trial balance. journal.
information in a ledger.
Source Documents

Source documents are documents where original information is found, for example, sales and
purchase invoices and credit notes.

Some examples:
• Invoice - a document sent to a customer by a seller, identifying a transaction for which the
customer owes payment to the seller.
• Credit note – a document sent to a customer showing the allowance given by a seller in
respect of returned goods
• Debit note – a document sent to a supplier showing the allowance to be given for returned
goods
• Paying-in slips - a small form that is filled in with the date and amount of money when
money are paid into the bank account
• Cheque counterfoil - the part of a cheque detached and retained as a record of the
transaction
• Receipt – the document that proves the receipt of cash or goods
Source Documents

Other

Invoices
Bank Statement

Journal
Check Stubs
Books of original (prime) entry

Known as ‘journals’ or ‘day books’

…. where transactions are initially recorded according to type (put same types of
transaction together) prior to them being posted to the ledger accounts.

• Cash book
• Sales day book – credit sales
• Purchases day book – credit purchases
• Sales Return day book
• Purchase Return day book
• Journal
Books of original (prime) entry

• Cash book – book of original entry used to enter cash and bank
receipts and payments.

• Sales day book - this book contains credit (non-cash) sales to

customers later posted to sales ledger.

• Sales return day book (returns inwards day book) - Recording

sales returned by buyers.
Books of original (prime) entry

• Purchases day book - this book contains credit (non-cash)

purchases.

• Purchases returns day book (returns outwards day book) –

this is used to record goods returned to suppliers.

• The Journal –Used for recording less common transactions.

Think Point

Can you recall:

• The Accounting Process

• List some examples of source documents

• Identify types of books of original (prime) entry

Steps in Processing Transactions

Assets = Liabilities + Equity

Step 2: Analyze
Step 1: Examine source transactions.
documents.

Equipment
30,000
GENERAL JOURNAL Page 123
Post.
Date Description Ref. Debit Credit

Bank
30,000
Step 3: Record
Step 5: Prepare a transactions in a
Step 4: Record the journal
trial balance. journal.
information in a ledger.
 The
The accounting Basic Accounting Equation
equation

Assets Liabilities Equity/Capital

= +

Provides the underlying framework for recording and

• Provides the underlying framework for recording and
summarizing economic events.
summarizing economic events.
• AppliesApplies to all economic
to all economic entities
entities regardlessof
regardless of size.
size.
• Dual aspect concept
The accounting equation

Resources owned by the business = Resources supplied by the owner

Assets = Capital

But if someone else (external people) has provided some of the assets:
Assets = Capital + Liabilities
Assets − Liabilities = Capital
A
-
L
=
A – L= C C
Capital/Assets/Liabilities: Basic definitions

Capital:
Resources supplied by the owner
Assets:
Actual resources in the business. What the business
owns.
Liabilities:
Amounts owing to third parties for the assets
of the business. What the business owes
 Capital

Capital is often called the owner’s equity or net worth. It comprises:

(i) the funds / resources invested in the business by the owner (ii) plus
any profits retained for use in the business (Revenues – Expenses).
NOTE: If loss rather than profit then deduct (less) as this will decrease
capital (owner's equity)

(iii) less drawings/ withdrawals by the owners (for sole traders and
partnerships) or dividends (for limited companies)
 Equity is the owner’s claim on assets
In a business EQUITY consists of four parts that either increase
or decrease equity:
Invested Revenues: Expenses:
Drawings:
Capital: What the What the
what the owner
What the company company pays
takes out of the
owner puts into receives for to operate the
business
the business sales business

INCREASESE DECREASE INCREASE DECREASE

Definition of Key terms
Drawing - Money, resources or items taken out of
business by owner for personal use.

Income - Money coming into the business.

Example: income from the sale of goods or provision
of services

Expenses - Resources spent or costs incurred in

running the business e.g. wages, salaries,
commissions paid, rent paid
Basic definition of Assets

Resources owned by the business

What the business owns

EQUIPMENT MOTOR VEHICLES

INVENTORY/STOCK
LAND & BUILDING
ACCOUNTS RECEIVABLE /
DEBTORS
CASH IN HAND
CASH AT BANK

PREPAYMENT
MACHINES
Assets

Inventory / stock – goods that are available for resale in other

words, goods that are bought with the intention to sell them to
customers

Assets include amounts owed to the business for goods bought and
services provided to customers that are yet to be paid for by the
customer (Accounts receivable / Debtors) and for expenses
overpaid i.e. not yet been incurred but have been paid for by the
business (Prepayment)
Basic definition of Liabilities

What the business owes / claims against a

business by people outside the business

ACCOUNTS PAYABLE /
CREDITORS

OVERDRAFT
LOANS

ACCRUALS
Liabilities

Liabilities include amounts owed by the business for goods and

services supplied to it that have not yet been paid for (Accounts
payable / Creditors) and for expenses incurred by it that have not
yet been paid for (Accruals)

Liabilities also include funds borrowed by the business for short

term (Overdraft) or long term (Loan).
Check Your Understanding
Classify the following into assets or liabilities:
(a) Business premises
(b) Bank overdraft
(c) Money owed by others to the business
(d) Equipment owned by the business
(e) Mortgage on premises
(f ) Cash held in till
(g) Unpaid bill
(h) Money owed to suppliers
(i)Computer used in the business
(j) Amount owing for office fixtures bought on credit.
The accounting equation
Resources owned by the business = Resources supplied by the owner
Assets = Capital
Example: the owner invests £2,000 cash in the business so
Assets £2,000 = Capital £2,000

But if someone else has provided some of the assets:

Assets = Capital + Liabilities
Example: If the business borrows £1,000 cash from a lender
Assets £2,000 + £1,000 = Capital £2,000 + Liabilities £1,000

And If the business uses its asset to provide another asset

Example: The business buys a computer paying £750 cash
Assets £2,000 + £1,000 + £750 - £750 = Capital £2,000 + Liabilities £1,000
The accounting equation

• The Accounting Equation in vertical format is the

basis of Balance Sheet / Statement of
Financial Position ‘outline’. (Future topic)

A
A–L=C -
L
=
C
Think point
Can you recall:
• The Accounting equation

Can you:
• Define and identify assets
• Describe and identify liabilities
• Explain capital (owner’s equity) and its components
• Indicate how accounting transactions affect the
items in the accounting equation
 The
The accounting Basic Accounting Equation
equation

Assets Liabilities Equity/Capital

= +

Provides the underlying framework for recording and

• Provides the underlying framework for recording and
summarizing economic events.
summarizing economic events.
• AppliesApplies to all economic
to all economic entities
entities regardlessof
regardless of size.
size.
The accounting equation
Resources owned by the business = Resources supplied by the owner
Assets = Capital
Example: the owner invests £2,000 cash in the business so
Assets £2,000 = Capital £2,000

But if someone else has provided some of the assets:

Assets = Capital + Liabilities
Example: If the business borrows £1,000 cash from a lender
Assets £2,000 + £1,000 = Capital £2,000 + Liabilities £1,000

And If the business uses its asset to provide another asset

Example: The business buys a computer paying £750 cash
Assets £2,000 + £1,000 + £750 - £750 = Capital £2,000 + Liabilities £1,000
Accounting Equation Example:
Transactions Effect on Accounting Equation
ASSETS = LIABILITIES + CAPITAL
Owner invests £10,000 in
the business by paying
cheque into the business
Bank
Business borrows £12,000
loan from Lloyds by cheque

Business buys an equipment

paying by cheque for £4,000

Business buys goods costing

£8,000 on credit from a
supplier
Owner withdrew £5,000 by
cheque from the business
for personal use
 Accounting Equation Example - Solution
Transactions Effect on Accounting Equation
ASSETS = LIABILITIES + CAPITAL
Owner invests £10,000 in the Assets (Bank) increase by Capital increases by
business by paying cheque into £10,000 £10,000
the business Bank
Business borrows £12,000 loan Assets (Bank) increase by Liabilities (Loan from
from Lloyds by cheque £12,000 Lloyds) increases by
£12,000
Business buys an equipment Assets (Equipment) increase
paying by cheque for £4,000 by £4,000

Assets (Bank) decrease by

£4,000
Business buys goods costing Assets (Inventory) increase Liabilities (Supplier)
£8,000 on credit from a supplier by £8,000 increases by £8,000

Owner withdrew £5,000 by Assets (Bank) decrease by Capital (drawings)

cheque from the business for £5,000 decreases by £5,000
personal use
References

• Sangster, A. (2018). Frank Wood’s Business Accounting. Volume

1. Fourteenth Edition. Pearson Education Limited.
• Wood, F., Horner, D. (2010), Frank Wood’s Business Accounting
Basics. Pearson Education Limited.
• Carey, M. et al (2011), Accounting, A Smart Approach, Oxford
University Press
• Cox, D. & Fardon, M. (2007), Accounting: A general introduction to
financial and management accounting. Osborn Books
intostudy.com/city