chapter 2 - assets liablities and the accounting equation

CHAPTER 2Assets, Liabilities and the Accounting Equation

Contents

Illustration

The accounting equation

Liabilities

Assets

Business definition

Business definition

A business owns assets and owes liabilities.

1

An organization which uses economic resources to create goods or services which customers will buy.

2

A business is an organization providing jobs for people to work in.

3

Invests money in resources (eg it buys buildings, machinery etc; it pays employees) inorder to make even more money for its owners.

A business from different perspectives

Legal:

• Separate legal entity

• No distinction with its owners.

A business

Accounting:

• Must always be treated as a separate entity from its owners.

Assets

Assets

Something valuable which a business owns or has the use of.

Non-current assets

Text

Current assets

Text

Items belonging to a business and used in the running of the business.

Assets classification

Non-current assets

• Held and used in operations for a long time, normally more than 1 years.

• E.g.: factories, office building, plant and machinery, cars, etc.

Current assets

• Held for only a shorter time.

• E.g.: Cash and banks, inventories, receivables, etc.

Classified by period of holding

Liabilities

Liabilities

Something which is owed to somebody else.

Non-current Liabilities

Text

Current Liabilities

Text

Sums of money owed by a business to outsiders

Liabilities classification

Non-current liabilities

• Payable in a long time, normally more than one year.

• E.g.: long term loans or borrowings from banks, etc.

Current liabilities

• Payable in a shorter time.

• E.g.: short term borrowings from banks, overdrafts, payables to suppliers, etc.

Classified by period of liabilities

The accounting equation

Very simple equation to keep in mind

Capital(Owners’ equity

Retained earnings)

Assets(Cash

ReceivablesBuildings

Cars)

Liabilities(Bank loans,

Trade payables Tax payables)

= +

A BusinessA Business

Example 1: Accounting equation On 1 September 20X8, Courtney

Wilder decides to open up a stall in the market, to sell West Indian fruit and vegetables.

He has saved up some money and has $1,000 to put into his business.

How’s the accounting equation?

Answer 1: Accounting equation

Capital$1,000

Assets$1,000 cash

Liabilities$0= +

Example 2: Different assets

Courtney Wilder purchases by cash a market stall which costs $600.

He also purchases some fruit and vegetables from a trader in the wholesale market at $340.

Of the remaining cash balance of $60, he keeps $30 in the bank and draws out $30 in small change, ready for his first day of market.

How does the accounting equation look now?

Answer 2: Different assets

Assets

Stall 600F&V 340Cash at bank 30Cash in hand 30

-----$1,000

= +

Capital

Initial capital $1,000

Liabilities

$0

Example 3: Profit

On 3 Sep, Courtney is able to sell all of his fruit and vegetables, for $500 cash.

How do we reflect this in the accounting equation?

Since he has sold goods costing $340 to earn revenue of $500, he has earned a profit of $(500 – 340) = $160 on the day's trading.

Answer 3: Profit

Assets

Stall 600F&V 0Cash (30+30+500) 560

-----$1,160

= +

Liabilities

$0

Capital

Initial capital 1,000Earned profit 160

-----$1,160

Example 4: Drawings

We will suppose that Courtney decides to pay himself $100 as 'wages', a fair reward for his day's work.

What’s the accounting treatment? And how’s the accounting equation?

Amounts taken out of a business by its owner.

Answer 4: Drawings

Any amounts paid by a business to its owners are treated by accountants as withdrawals, not as expenses incurred by the business.

Assets

Stall 600F&V 0Cash (560-100) 460

-----$1,060

= +

Liabilities

$0

Capital

Initial capital 1,000Earned profit 160Drawings (100)

-----$1,060

Accounting equation 2

Capital introduced + earned

profit - drawings

Assets Liabilities= +



Capital introduced + profit retained

in previous periods+ profit

earned in current period

- drawings



Q: Equation analysis

(a) The bank tells the business it no longer owes the bank $100 in bank charges.

(b) The business finds it has been overcharged $50 for some furniture it bought on credit.

(c) A gas bill of $200 is received by the business.

(d) The owner withdraws $500 from the business.

(e) Cash is introduced into the business by its owner.

(f) A car is bought by the business, for payment in 1 month's time.

A: Equation analysis

Transaction Assets = Capital + Liabilities

(a) Increase Decrease

(b) Decrease Decrease

(c) Decrease Increase

(d) Decrease Decrease

(e) Increase Increase

(f) Increase Increase

Example 5: More profit

On 10 Sep, Courtney purchases more F&V for cash, at a cost of $400. His aunt, Sheila, offers to help and he agrees to pay a wage of $50.

They sell all their goods for $760 cash. Courtney pays Sheila her wage of $50

and draws out $150 for himself. Update the accounting equation now?

Answer 5: More profit

Before trading:

Assets

Stall 600F&V 400Cash (460-400) 60

-----$1,060

= +

Liabilities

$0

Capital

Initial capital 1,000Retained profit 60

----- $1,060

Answer 5: More profit (con ’t)

After trading:

Assets

Stall 600F&V 0Cash(60+760-50-150) 620

-----$1,220

= +

Liabilities

$0

Capital

Capital b/f 1,060Earned profit(760-400-50) 310Drawings (150)

-----$1,220

Example 6: More capital introduced

Suppose on 10 Sep, in addition to all the other transactions, Courtney decides to hire a van at a cost of $30 to transport the fruit and vegetables, paying for the hire out of cash from his own pocket.

How would this affect the accounting equation at the end of 10 September?

Answer 6: More capital introduced

Assets

Stall 600F&V 0Cash (60+760+30-50-30-150) 620

-----$1,220

= +

Liabilities

$0

Capital

Capital b/f 1,060Capital introduced 30Earned profit (760-400-50-30) 280Drawings (150)

-----$1,220


Capital introduced in previous periods

+ Profit retained in previous periods

+ Profit earned in current period

+ Capital introduced in current period

– Drawings in current period



The business equation

Profit earned in current period

Drawings in current period

Increase/decrease in net assets in

current period

Capital introduced in current

period

= + -

Credit transactions

Credit sales

• Creates an account receivable

• Settled when cash is received from customer

Purchases on credit

• Creates an account payable

• Settled when cash is paid to supplier

A sale or a purchase which occurs some time earlier than cash is received or paid.A sale or a purchase which occurs some

time earlier than cash is received or paid.

Example 7a: Credit transactions

(a) Courtney makes the following arrangements.(i) He invests immediately a further $200 of his own capital.(ii) He persuades his cousin Gary to lend him $400 immediately. Gary tells him that he can repay the loan whenever he likes, but in the meantime he must pay him interest of $3 per week each week at the end of the market day. They agree that it will probably be quite a long time before the loan is eventually repaid.

Answer 7a: Credit transactions

Assets

Stall 600Goods 0Cash (620+200+400) 1,220

-----$1,820

= +

Liabilities

Loan

400

-----

$400

Capital

Capital b/f 1,220Capital introduced 200

-----$1,420

Example 7b: Credit transactions

(b) Courtney is very pleased with the progress of his business, and decides that he can afford to buy a second-hand van to pick up fruit and vegetables from his supplier and bring them to his stall in the market. He finds a car dealer, Carrie Carver, who agrees to sell him a van on credit for $550. Courtney agrees to pay for the van after 30 days' trial use.

Answer 7b: Credit transactions

Assets

Stall 600Van 550Cash 1,220

-----$2,370

= +

Liabilities

Loan

400Creditor

550

-----

$950

Capital

Capital b/f 1,220Capital introduced 200

-----$1,420

Example 7c: Credit transactions

(c) During the week before the next market day (which is on 17 September), Courtney's Uncle Viv telephones him to ask whether he would be interested in selling him some special West Indian spices and equipment for his kitchen. Courtney tells him that he will look for a supplier. After some investigations, he buys what Uncle Viv has asked for, paying $250 in cash to the supplier. Uncle Viv accepts delivery of the goods and agrees to pay $320 at a later date.

Answer 7c: Credit transactions

Assets

Stall 600Van 550Receivable 320Cash (1,220-250) 970

-----$2,440

= +

Liabilities

Loan

400Creditor

550

-----

$950

Capital

Capital b/f 1,220Capital introduced 200Profit from Viv(320-250) 70

-----$1,490

Example 7d: Credit transactions

(d) The next market day approaches, and Courtney buys fruit and vegetables costing $650. Of these purchases $550 are paid in cash, with the remaining $100 on 14 days' credit. Courtney decides to use his aunt Sheila's services again as an assistant on market day, at an agreed wage of $50.

Answer 7d: Credit transactions

Assets

Stall 600Goods 650Van 550Receivable 320Cash (970-550) 420

-----$2,540

= +

Liabilities

Loan

400Payable for van

550Payable for goods

100

-----

$1,050

Capital

Capital b/f 1,220Capital introduced 200Profit from Viv 70

-----$1,490

Example 7e: Credit transactions

(e) For the third market day running, on 17 September, Courtney sells all his goods, earning $1,050 (all in cash). He decides to take out drawings of $200 for his week's work. He also pays Sheila $50 in cash. He decides to make the interest payment to his cousin Gary the next time he sees him.

Answer 7e: Credit transactions

Assets

Stall 600Van 550Receivable 320Cash (420+1,050-50-200) 1,220

-----$2,690

= +

Liabilities

Loan

400Payable for van

550Payable for goods

100Interest payable

3

-----

$1,053

Capital

Capital b/f 1,490Profit for week (1,050-650-50-3) 347Drawings (200)

-----$1,637

Question

Liza Doolittle has $2,500 of capital invested in her business. Of this, only $1,750 has been provided by herself, the balance being provided by a loan of $750 from Professor Higgins. What are the implications of this for the accounting equation?

Answer

Assets of $2,500 (cash), balanced by liabilities of $2,500.

$1,750 owed to Liza clearly falls into the capital.

$750 owed to the Professor? Sharing the risks and rewards of the business, then $750

is 'capital’. Expect only a repayment of his 'loan' plus some interest,

$750 should be classified under liabilities.

Double entry bookkeeping

Debit:

• Increases assets• Decreases liabilities• Decreases capital• Decreases income• Increases expenses

Means left hand side

A businessDuality: Every transaction has two accounting entries, a debit and a credit.

Duality: Every transaction has two accounting entries, a debit and a credit.

Credit:

• Decreases assets• Increases liabilities• Increases capital• Increases income• Decreases expenses

Means right hand side

DiscussionExplain the dual effects of each of the following

transactions.

(a)A business receives a loan of $5,000 from its bank

DR assets (cash) and CR liabilities (owed to the bank) by $5,000.

(b) A business pays $800 cash to purchase goods for resale

CR assets (cash) and DR assets (inventory) by $800.

Discussion

(c) The proprietor of a business removes $50 from the till to buy her husband a birthday presentCR assets (cash) and DR capital by $50.

(d) A business sells goods costing $300 at a profit of $140DR assets (cash) by $440; CR assets (inventory) by $300; and CR capital (the profit earned) by $140.

(e) A business repays a $5,000 bank loan, plus interest of $270CR assets (cash) by $5,270; DR liabilities (the bank loan) by $5,000; and DR capital by $270.

MCQ 1

A business had net assets at 1 January and 31 December 20X9 of $75,600 and $73,800 respectively. During the year, the proprietor introduced additional capital of $17,700 and withdrew cash and goods to the value of $16,300.

What profit or loss was made by the business in 20X9?

A $3,200 lossB $400 lossC $400 profitD $3,200 profit

MCQ 1

A business had net assets at 1 January and 31 December 20X9 of $75,600 and $73,800 respectively. During the year, the proprietor introduced additional capital of $17,700 and withdrew cash and goods to the value of $16,300.


A $3,200 loss (73,800-75,600-17,700+16,300)B $400 lossC $400 profitD $3,200 profit

MCQ 2

A business had net assets at 1 January and 31 December 20X9 of $47,100 and $54,200 respectively. During the year the proprietor introduced additional capital of $22,000 and made drawings of $200 per week.


A $18,700 lossB $4,500 lossC $4,500 profitD $18,700 profit

MCQ 2

A business had net assets at 1 January and 31 December 20X9 of $47,100 and $54,200 respectively. During the year the proprietor introduced additional capital of $22,000 and made drawings of $200 per week.


A $18,700 lossB $4,500 loss (54,200 – 47,100 -22,000 + 200*52)C $4,500 profitD $18,700 profit

MCQ 4

The net assets of Kate's business were $15,000 at 1 January 20X3 and $25,000 at 31 December 20X3. During the year Kate paid lottery winnings of $2,500 into the business bank account and withdrew $1,000.What was her net profit for the year ended 31 December 20X3?

A $7,500B $8,500C $9,500D $11,500

MCQ 4

The net assets of Kate's business were $15,000 at 1 January 20X3 and $25,000 at 31 December 20X3. During the year Kate paid lottery winnings of $2,500 into the business bank account and withdrew $1,000.What was her net profit for the year ended 31 December 20X3?

A $7,500B $8,500 (25,000 – 15,000 -2,500 + 1,000)C $9,500D $11,500

QB 3

3 The double-entry system of bookkeeping normally results in which of the following balances on the ledger accounts?

Debit balances Credit balances

A Assets and revenues Liabilities, capital and expenses

B Revenues, capital and liabilities

Assets and expenses

C Assets and expenses Liabilities, capital and revenues

D Assets, expenses and capital

Liabilities and revenues

Answer: C

chapter 2 - assets liablities and the accounting equation

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