Chapter 2: The Accounting Equation PDF

## Chapter 2: The Accounting Equation ### Introduction * Learning Outcomes * Record and account for transactions and events resulting in income, expenses, assets, liabilities, and capital in accordance with the appropriate basis of accounting and the laws, regulations, and accounting standard...

## Chapter 2: The Accounting Equation ### Introduction * Learning Outcomes * Record and account for transactions and events resulting in income, expenses, assets, liabilities, and capital in accordance with the appropriate basis of accounting and the laws, regulations, and accounting standards applicable to the financial statements. * Identify the main components of a set of financial statements and specify their purpose and interrelationship. * Syllabus Links * The material in this chapter will be developed further in this exam, and then in Professional Level Financial Accounting and Reporting. * Examination Context * Questions on the topics in this chapter will be set as multiple choice, multi-part multiple choice or multiple-response questions, some of which may involve calculations so that the correct answer can be selected. * In the exam you may be required to: * identify and manipulate the accounting equation * specify transactions affecting the elements of financial statements: assets, liabilities, capital, income, and expenditure. ### Learning Topics: 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 ### Assets, Liabilities, and the Business Entity Concept - Section Overview * Assets are present economic resources controlled by the entity as a result of past events. * Liabilities are present obligations of the entity as a result of past events. * A business entity is a separate entity from its owners from an accounting point of view, regardless of its legal structure. #### Assets and Liabilities - **Definition** Assets are a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. * Assets are key to financial statements. * Examples of Assets: * Land and buildings: factories, office buildings, storage and distribution centers * Motor vehicles * Plant and machinery * Fixtures and fittings: computer equipment, office furniture and shelving * Software, capitalised development costs, licenses, quotas (known as intangible assets) * Cash: in a bank account or held as notes and coins. * Inventory: goods held in store awaiting sale to customers, and raw materials and components held in store for use in production. * Receivables: amounts owed by customers and others to the entity. * Some assets are expected to generate economic benefits over a number of years. An office building is occupied by administrative staff for years: similarly, a machine has a useful life of many years before it wears out. These are _non-current assets_. * Other assets are expected to generate economic benefits in the short term. A newsagent, for example, has to sell his newspapers on the same day that he gets them. The quicker a business sells goods, the more profit it is likely to make, provided, of course, that the goods are sold at a higher price than what it cost the business to acquire them. _Short-term assets_ are called _current assets_. - **Definition** Liabilities are a present obligation of the entity to transfer an economic resource as a result of past events. * Liabilities are a key element of financial statements. * Examples of Liabilities: * A bank loan or overdraft: the liability is the amount eventually repaid to the bank. * Payables: amounts owed to suppliers for goods purchased but not yet paid for; for example, a boatbuilder buys some timber on credit from a timber merchant. * Taxation owed to the government. A business pays tax on its profits but there is a gap in time between when a business declares its profits (and becomes liable to pay tax) and the payment date. * Liabilities for which economic resources are expected to be transferred in the next 12 months are _current_. Liabilities for which economic resources are expected to be transferred in more than 12 months are _non-current_. #### The Business as a Separate Entity - **Context Example: Sole Trader** A sole trader starts business as a hairdresser, trading under the business name "Quiff's Hair Salon". The law recognizes no distinction between the sole trader, the individual, and the business known as "Quiff's Hair Salon". Any debts of the business which cannot be met from business assets must be met from the sole trader's personal resources. However, in accounting any business is treated as a separate entity from its owner(s). This applies whether or not the business is recognized in law as a separate entity, i.e., it applies whether the business is carried on by a company or by a sole trader. - **Definition** Business Entity Concept: A business is a separate entity from its owner. * Although this may seem illogical and unrealistic, you must try to appreciate it, as it is the basis of a fundamental rule of accounting. - **Context Example: The Business as a Separate Entity** On 1 July 20X6, Charlie opened a flower stall. They had saved up CU2,500 and opened a business bank account with this amount. When the business commences, an accountant's picture can be drawn of what it owns and what it owes. The business begins by owning the cash that Charlie has put into it, CU2,500. * The business is a separate entity in accounting terms. It has obtained assets, from Charlie. It therefore owes this amount of money to Charlie. - **Definition** Capital is the residual interest in the assets of the entity after deducting all of its liabilities. * Equity is a key element of financial statements. * In simple terms, capital can be viewed as a measure of the owner's investment in the business. ### The Accounting Equation - **Section Overview** * The basic accounting equation states that assets = capital + liabilities. * Capital is the amount that the entity owes to its owners. #### What is the Accounting Equation - **Definition** Assets = Capital + Liabilities * We will use an example to illustrate the accounting equation, i.e., the rule that the assets of a business will at all times equal its liabilities plus capital. This is also known as the _balance sheet equation_. #### Assets = Capital + Liabilities - **Context Example: Assets = Capital** Continuing from "The Business as a Separate Entity" example above, the business began by owning the cash that Charlie has put into it, CU2,500. The business is a separate entity in accounting terms and so it owes the money to Charlie as capital. * In accounting, capital is an investment of money (funds) with the intention of earning a return. A business owner invests capital with the intention of earning profit. As long as that money is invested, accountants will treat the capital as money owed to the owner by the business. - **Context Example: Different Types of Assets = Capital** Charlie purchases a market stall for CU1,800. They also purchase some flowers from a trader in the wholesale market, at a cost of CU650. * The stall and the flowers are physical items, but they must be given a money value. This money value is usually what they cost the business (called _historical cost_ in accounting terms). #### Where do Profits/Losses Fit into the Accounting Equation? - **Context Example: Assets = Capital + Profit** Since Charlie has sold goods costing CU650 to earn income of CU900, we can say that they have earned a profit of CU250 on the day's trading. * Profits are added to the owner's capital. In this case, the CU250 belongs to Charlie. However, so long as the business retains the profits and does not pay anything out to its owner, the retained profits are accounted for as an addition to the owner's (Charlie) capital. - **Definitions** * Profit: The excess of income over expenses. * Loss: The excess of expenses over income. * Income: Income is "increases in assets or decreases in liabilities that result in increases in equity (capital), other than those relating to contributions from holders of equity claims." * Expenses: Expenses are "decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims." * Thus: * Profits are added to owner's capital. * Losses are deducted from owner's capital. * Note that the Conceptual Framework identifies income and expenses, and assets, liabilities, and equity, as the elements of financial statements. Each element represents a class of transactions or other events that are grouped together according to their economic characteristics. #### Appropriation of Profits: Sole Trader Drawings - **Definition** Drawings are money and goods taken out of a business by its owner. - **Context Example: Appropriations of Profit** Business owners, like everyone else, need income for living expenses. Charlie therefore decides to take CU180 from the business in "wages." The payment of CU180 is regarded by Charlie as a fair reward for their day's work and they might think of the sum as "wages." However, the CU180 Charlie draws is not an expense to be deducted in arriving at the figure of profit because any amounts paid by a business to its owner are treated by accountants as withdrawals or appropriations of profit and not as expenses incurred by the business. * Profits are capital as long as they are retained in the business. Once they are appropriated, the business suffers a reduction in capital. - **Context Example: Assets = Capital** On 10 July Charlie purchases flowers for cash, at a cost of CU740. Charlie decides to employ their cousin for a wage of CU40 for the day.