Elements/Foundations of Accounting

Lecture 2
LAKATOS, László Péter

© Lakatos

2
3
4
5

Effects of business on the

balance sheet
Corvinus University of Budapest Understanding Financial Statements 2

1
 © Lakatos

When business is being done…

In the ordinary course of business, constant changes occur in the amount and the
structure of the items of the statement of financial position. These changes are
referred to as (business) transactions.

Nothing can change on its own! Why?

Assets = Owners' equity + Liabilities

Corvinus University of Budapest Understanding Financial Statements 3

Types of business transactions

Liability + Controlled assets

Type #1 Asset +
Owners' Equity + changed

Liability - Controlled assets

Type #2 Asset -
Owners' Equity - changed

Type #3 Asset + Asset - Structure changed

Liability + Liability -
Type #4 Structure changed
Owners' Equity + Owners' Equity -

2
 © Lakatos

Avon case study – do the changes in the balance sheet!

These transactions happened to AVON during September 20X1:

Day 1: Avon commences business introducing $ 1 000 cash.

Day 2: Buys a motor car for $ 400 cash.
Day 3: Buys inventory for $ 200 cash.
Day 4: Sells all the goods bought on Day 3 for $ 300 cash.
Day 5: Buys inventory for $ 400 on credit.

Corvinus University of Budapest Understanding Financial Statements 5

© Lakatos

Avon case study – continued…

Day 6: Sells half of the goods bought on Day 5 on credit for $250.
Day 7: Pays $200 his supplier.
Day 8: Receives $100 from a customer.
Day 9: Proprietor draws $75 in cash.
Day 10: Pays rent of $40 in cash.
Day 11: Receives a loan of $600 repayable in two years.
Day 12: Pays cash of $30 for insurance.

Corvinus University of Budapest Understanding Financial Statements 6

3
 © Lakatos
The structure of the balance sheet

Statement of financial position, 31st December 20X1

Non current assets Owners' equity
Tangible assets Capital
Intangible assets Reserves

Current assets Liabilities

Inventory Long term liabilities
Receivables Short term liabilities
Cash and cash equivalents

Corvinus University of Budapest Understanding Financial Statements 7

Avon solution
8

4
 AVON/0) 31/08 Incr. (+) Decr. (-) 12/09
Non-current assets 0
Tangible assets
Intangible assets

Current assets 0
Inventory

Receivables
A/R
Cash&cash
equivalents

TOTAL ASSETS 0

AVON/0) 31/08 Decr. (-) Incr. (+) 12/09

Owners' equity 0
Capital
PROFIT/
Retained
earnings
(Reserves)
Drawings (-)
Liabilities 0
Long-term liab.
Long-term
loans
Short-term liab.
A/P

TOTAL EQ & LIA 0

10

5
 Transaction 4: the profit!

What happened? A SALE! We sell an item for more than what we have purchased it for.

See? The transaction has two components. An „incoming item” and an „outgoing item”.

Incoming value ≠ Outgoing value

What is the difference? PROFIT GENERATED BY THE ENTITY. Where does it go?
To RESERVES

11

So, what is profit?

That flowed TO
Income
the entity
Profit
That was taken
Expense AWAY from the
entity.
This is not coming from the owner
but generated by the entity

Issued
Introduced
capital
Equity
Generated Reserves

12

6
 Transaction 10

There is an outflow but NO inflow

So, this means… no income

This is called (operating) expense

13