Lesson 2-4 The Accounting Equation

Orutt Academy Finance & Accounting

Unit 1: Basic Accounting Concepts

LESSONS:2.THE ACCOUNTING EQUATION

3. ASSETS4. LIABILITIES

5. OWNER’S EQUITY

Lesson 2THE ACCOUNTING

EQUATION

Accounting as a whole is based on a single equation:

ASSETS = EQUITY + LIABILITIES

THE ACCOUNTING EQUATION

The word equation comes from the word equal. For any equation, one side always equals another.

EQUATION

The accounting equation should remain in balance at all times because of double-entry accounting or bookkeeping.

Double-entry means that every transaction will aff ect at least two accounts in the general ledger.

DOUBLE ENTRY

Examples An owner's investment into the company will increase the

company's assets and will also increase owner's equity. When the company borrows money from its bank, the

company's assets increase and the company's liabilities increase.

EXAMPLES OF DOUBLE ENTRY

Well, in order to answer that question we need to look at what each of the terms in the equation mean…

1. Assets2. Liabilities

3. Owner’s Equity

SO WHAT DOES THE ACCOUNTING EQUATION MEAN?

Lesson 3ASSETS

Offi cial Definition: A resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.

WHAT IS AN ASSET?

An asset is A possession of a business that will bring the

business benefits in the future. Anything that will add future value to your business.

IN OTHER WORDS…

LandComputerVehicleCash

EXAMPLES

Debtors are people that owe your business money and the value of these debts as a whole.

Another name for debtors is accounts receivable. The word receivable simply means capable of being received, or will be received.

DEBTORS

Would debtors or accounts receivable be an asset for your business? Answer: Even though you cannot own a debtor, you will get

benefits in the future from having money owed to your business.

The benefits are simple – you will get paid! So if you have $3,000 owed to you by Mr. Smith, you have a debtor, an asset, worth $3,000.

ARE DEBTORS AN ASSET?

An additional requirement for an asset is that you have to be able to accurately measure its value.

This is usually quite simple, as the value is equal to how much you paid for it.

Are employees considered an asset? Can you put an accurate, reliable figure on how much an

employee is worth to you, bearing in mind that he or she can resign at any point by giving notice? Tricky, right? As you can imagine, it's nearly impossible to place a value on people – consequently employees are actually never included as assets in accounting - but only because we can't value them.

MEASURABLE VALUE

1. DOES YOUR BUSINESS OWN/CONTROL IT?2. WILL IT BRING YOUR BUSINESS BENEFITS IN

THE FUTURE?3. CAN YOU VALUE IT ACCURATELY?

SO THE FULL TEST OF WHETHER SOMETHING IS AN ASSET IS:

The cost of an asset includes all costs necessary to get it to the business premises and into a condition in which it can be sold. So the cost of an asset can include the following: Purchase price Import duties,

- Transport costs to get it to your premises,- Installation or set-up costs.

HOW TO VALUE AN ASSET

Decrease Assets Increase Assets

Purchasing Supplies (The asset account Cash decreases)

Purchasing Supplies (The asset account Supplies increases)

Owner Draws Owner Contributions

Repaying bank loans Receiving bank loans

Credit purchases

CHANGES IN ASSETS

Lesson 4LIABILITIES

A present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

WHAT IS A LIABILITY?

a liability is simply... a debt of the business.The debt will result in assets (usually cash) leaving

the business in the future.

IN OTHER WORDS…

The most common liability is a loan. Another common liability is called creditors.

A creditor, also known as a payable, is any business or person (apart from the bank) that you owe.

Suppliers (who you owe for products purchased on credit) would fall under creditors.

EXAMPLES

Decrease Liabilities Increase Liabilities

Repaying a bank loan Receiving a bank loan

Credit Payments Credit purchases

Paying Creditors Notes payable to creditors

CHANGES IN LIABILITIES

Lesson 5OWNER’S EQUITY

The residual interest in the assets of the enterprise after deducting all its liabilities.

WHAT IS OWNER’S EQUITY

The owner’s equity is simply the owner’s share of the assets of a business.

IN OTHER WORDS…

Represents the value of the assets that the owner can lay claim to.

The value of all the assets after deducting the value of assets needed to pay liabilities.

It is the value of the assets that the owner really owns.

OWNER’S EQUITY = ASSETS - LIABILITIES

OWNER’S EQUITY

ASSETS = EQUITY + LIABILITIESThe accounting equation indicates how much of

the assets of a business belong to, or are owned, by whom.

Assets can only ‘belong’ to two types of people: people outside the business who are owed money

(liabilities) the owner himself (owner’s equity).

THE ACCOUNTING EQUATION

In the case of a corporation, which is publicly owned, equity is labeled shareholder’s equity

SHAREHOLDER’S EQUITY

Decrease Owner’s Equity Increase Owner’s Equity

Expenses Revenues

Losses Gains

Owner withdraws Owner investments

Beginning Capital

CHANGES IN OWNER’S EQUITY

IncomeExample: a service company earns revenue when it

provides services to its clientsRecorded as an increases in owner’s equity and an

increase in assets

REVENUES

The costs the company incurs in carrying on operations in its eff ort to create revenue

Decrease owner’s equityCan be paid for with cash (decreases assets)Or charged (increase liabilities)

EXPENSES

The diff erence between expenses and equipment is equipment can be liquidated or converted to cash.

EXAMPLE: A company car is equipment: No affect on owner’s equity. A telephone bill is an expense Decreases owner’s equity.

EXPENSES VS. EQUIPMENT

Net Income: The company is bringing in more money than it is spending to continue operations. Revenues > Expenses

Net Loss: The company is bringing in less money than it is spending to continue operations Revenues < Expenses

Break Even: When a company’s revenues are equal to their expenses

NET INCOME VS. NET LOSS

OWNER’S EQUITY

Beginning CapitalPLUS

Additional Investment

Net Income*

Revenues -- Expenses

Withdraws+ --

If expenses are greater than revenues, then a net loss would result. This loss would be subtracted from capital because it would be a

negative number.

1. The basic accounting equation is assets = liabilities + ______________ ______________.

THE ACCOUNTING EQUATION WORKSHEET

For each of the transactions in items 2 through 9, indicate the two (or more) eff ects on the accounting equation of the business or company.

#2

IDENTIFYING CHANGES IN THE ACCOUNTING EQUATION

The owner invests personal cash in the business.

Assets: Increase Decrease No Effect

Liabilities: Increase Decrease No Effect

Owner's (or Stockholders') Equity:

Increase Decrease No Effect

#3


The owner withdraws business assets for personal use.





#4


The company receives cash from a bank loan.





#5


The company repays the bank that had lent money to the company.





#6


The company purchases equipment with its cash.





#7


The owner contributes her personal truck to the business





#8


The company purchases a significant amount of equipment on credit.





#9


The company purchases land by paying half in cash and signing a note payable for the other half.





Economy & Finance

Lesson 2-4 The Accounting Equation