Slide 2.1

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Chapter 2

A Systematic approach to financial reporting:

the accounting equation

Slide 2.2

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Assets and liabilities

Assets

• Resources available to the business.

Liabilities

• Obligations of the business.

Slide 2.3

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Assets minus Liabilities equal Ownership interest

The accounting equation

Statement of financial position

A – L = OI

Slide 2.4

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

The ownership interest is the residual claim after liabilities to third parties have been satisfied.

The accounting equation (Continued)

A – L OI

Slide 2.5

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Alternative ways of expressing the accounting equation

Assets equal Ownership interest plus Liabilities

A = OI + L

Slide 2.6

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

A = OI + L

Alternative ways of expressing the accounting equation (Continued)

OI + LA

Slide 2.7

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Definition of an asset

A resource

• controlled by the entity,

• as a result of past events,

• and from which future economic benefits are expected to flow to the entity.

Slide 2.8

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Analysis of definition

• Controlled by an entity: Can we restrict access to the item?

• Past events: Has an agreement or event taken place that has resulted in the organisation obtaining control of the item?

• Future economic benefits: Will cash be generated in the future?

Slide 2.9

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Examples of assets

• Land and buildings owned by a business.

• Raw materials owned by the business.

• Workforce employed by the business.

• Major advertising campaign undertaken by the business.

Slide 2.10

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Recognition

Recognised as an asset (i.e. reported in the balance sheet)?

Only if

• It is probable that the future economic benefits will flow to the entity

• and the asset has a cost or value that can be measured reliably.

Slide 2.11

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Recognise Not recognise

Land and buildings Workforce

Raw materials Advertising campaign

Why? Why?

Relative certainty of future benefit

Uncertainty of benefits: lack of evidence that cash will flow to the business in the future.

Recognise or not?

Slide 2.12

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Definition of a liability

• a present obligation of the entity.

• arising from past events.

• the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

Slide 2.13

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Analysis of definition

• Present obligation: legal or as a result of commercial reality.

• Past events: normally receiving goods or services or borrowing money.

• Outflow embodying economic benefits: cash or other resource leaving the business.

Slide 2.14

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Recognition of liability

• Is there sufficient evidence that outflow of benefit (cash or other resources) will occur?

• Can the obligation be measured reliably?

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Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Examples of liability

• Bank borrowing by the business.

• Sales tax (VAT) payable by a business based on past sales.

Slide 2.16

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Liabilities not recognised

• An item that fails the recognition test (not reported in the balance sheet) might well be reported in the notes to the accounts as a ‘contingent liability’.

• Example of the ‘prudent’ nature of financial reporting practice.

• For example: Potential liability for defective products. (Will a legal action actually be undertaken?)

Slide 2.17

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Ownership interest

• The ownership interest is the residual amount found by deducting all of the entity’s liabilities from all of the entity’s assets.

• The term net assets is used as a shorter way of saying ‘total assets less total liabilities’.

• Recognition totally dependent on the recognition of assets and liabilities.

Slide 2.18

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Changes in ownership interest

• Compare the financial position of the business at two points in time.

• At time t = 0• Assets(t0) – Liabilities(t0) = Ownership

interest(t0)• At time t = 1• Assets(t1) – Liabilities(t1) = Ownership

interest(t1)

Slide 2.19

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Change in (Assets – Liabilities)

orChange in Net assets

= Change in Ownership interest

Subtracting

Slide 2.20

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Causes of change in OI

• Normal business transactions: supplying goods and services to customers.

• Owner contributing resources to the business (Invest cash in the business)

or

• Owner withdrawing resources from the business (withdraw cash from the business).

Slide 2.21

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Revenue and expense

• Revenue: increase in ownership interest (i.e. increase in net assets).

Providing a service to a customer for which payment is made.

• Expense: decrease in ownership interest (i.e. decrease in net assets).

Cost of providing a service to a customer.

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Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Revenue minus Expenses

= Profit

Net impact of business transactions

Slide 2.23

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Change in ownership interest

equals Capital contributed/withdrawnby the ownership plus Revenue minus Expenses

Equation for change in ownershipinterest

Slide 2.24

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Assetsminus Liabilitiesat the end of the period

equal Ownership interest at the start of the periodplus Capital contributed/withdrawn in the period plus profits for the period

Equation for change in ownership interest (Continued)

Slide 2.25

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Chapter 2

Bookkeeping Supplement

Slide 2.26

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

LEFT-HAND SIDE

Assets Increase Decrease

RIGHT-HAND SIDE

Liabilities Decrease Increase

Ownership interest Decrease Increase

Assets equal Ownership interest plus

Liabilities

Accounting equation

Slide 2.27

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Rules

1. Ask yourself: Is this item an asset or a liability or a part of the ownership interest?

2. Choose the line in the table.

asset

liability

ownership interest

Slide 2.28

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

?? ??

Asset Increase Decrease

Liability Decrease Increase

Ownership interest

Decrease Increase

3. Ask yourself: Has the item increased or decreased?

4. Choose the box that contains the answer.

Rules (Continued)

Slide 2.29

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Asset Increase Decrease

Liability Decrease Increase

Ownership interest Decrease Increase

ACTION TO TAKE DEBIT ENTRIES IN A LEDGER ACCOUNT

CREDIT ENTRIES IN A LEDGER ACCOUNT

5. Make a debit entry or a credit entry

Rules (Continued)

Slide 2.30

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Ownership interest

The ownership interest may be increased by:

• Earning revenue

• New capital contributed by the owner

The ownership interest may be decreased by:

• Incurring expenses

• Capital withdrawn by the owner

Slide 2.31

Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

DEBIT ENTRIES CREDIT ENTRIES

Left-hand side of the equation

Asset Increase Decrease

Right-hand side of the equation

Liability Decrease Increase

Ownership interest Expense Revenue

Capital withdrawn Capital contributed

Ownership interest (Continued)