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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= +
A BusinessA Business
Accounting equation 3
Capital introduced + profit retained
in previous periods+ profit
earned in current period
- drawings
Assets Liabilities= +
A BusinessA Business
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
Accounting equation 4
Capital introduced in previous periods
+ Profit retained in previous periods
+ Profit earned in current period
+ Capital introduced in current period
– Drawings in current period
Assets Liabilities= +
A BusinessA Business
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.
What profit or loss was made by the business in 20X9?
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.
What profit or loss was made by the business in 20X9?
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.
What profit or loss was made by the business in 20X9?
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
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