Chapter 2 - Assets Liablities And The Accounting Equation

CHAPTER 2 Assets, Liabilities and the Accounting Equation

Contents Business definition Assets

Liabilities The accounting equation Illustration

Business definition 1 An organization which uses economic resources to create goods or services which customers will buy.



2

3

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

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

A business owns assets and owes liabilities.

A business from different perspectives A business

Legal:

Accounting:

•Separate legal entity •No distinction with its owners.

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

Assets

Non-current assets

Text

Assets

Current assets

Text

Something valuable which a business owns or has the use of. Items belonging to a business and used in the running of the business.

Assets classification Classified by period of holding Non-current

•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.

Liabilities

Non-current Liabilities Text

Liabilitie s

Current Liabilities Text

Something which is owed to somebody else. Sums of money owed by a business to outsiders

Liabilities classification Classified by period of liabilities Non-current

•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.

The accounting equation A Business

Assets (Cash Receivables Buildings Cars)



Capital =

(Owners’ equity Retained earnings)

Liabilities +

(Bank loans, Trade payables Tax payables)

Very simple equation to keep in mind

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 Assets $1,000 cash

=

Capital $1,000

+

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 

Answer 2: Different assets Assets Stall F&V Cash at bank Cash in hand

Liabilities

Capital 600 340 30 30 ----$1,000

=

Initial capital

$1,000

+

$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 600 F&V 0 Cash (30+30+500) 560 ----$1,160

Liabilities

Capital =

Initial capital Earned profit

1,000 160 ----$1,160

+

$0

Example 4: Drawings Amounts taken out of a business by its owner. 

 

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?

Answer 4: Drawings Capital

Assets

Initial capital

Stall 600 F&V 0 Cash (560-100) 460 ----$1,060



Liabilities

1,000 Earned profit

=

160 Drawings

+

$0

(100) ----$1,060

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

Accounting equation 2 A Business

Assets

=

Capital introduced + earned profit drawings

+

Liabilities

Accounting equation 3 A Business

Assets

=

Capital introduced + profit retained in previous periods+ profit earned in current period drawings

+

Liabilities

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

A: Equation analysis

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:

Stall F&V Cash (460-400)

Liabilities

Capital

Assets 600 400 60 ----$1,060

=

Initial capital 1,000 Retained profit 60 ----$1,060

+

$0

Answer 5: More profit (con ’t) 

After trading:

Assets Stall

Capital

600 F&V 0 Cash

=

Capital b/f Earned profit (760-400-50) Drawings

Liabilities 1,060 310 (150)

(60+760-50-150) 620 ----$1,220

----$1,220

+

$0

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 Capital

Assets Stall F&V Cash (60+760+30 -50-30-150)

600 0 620 ----$1,220

=

Capital b/f Capital introduced Earned profit (760 -400-50-30) Drawings

Liabilities 1,060 30 280 (150) ----$1,220

+

$0

Accounting equation 4 A Business

Assets

=

Capital introduced in previous periods + Profit retained in previous periods + Profit earned in current period + Capital introduced in current period – Drawings in current period

+

Liabilities

The business equation

Profit earned in current period

=

Increase/dec rease in net assets in current period

+

Drawings in current period

-

Capital introduced in current period

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

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

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

Answer 7a: Credit transactions Liabilities Assets Stall Goods Cash (620+200+400)

Capital 600 0 1,220 ----$1,820

=

Capital b/f Capital introduced

Loan 1,220 200 ----$1,420

400

+ ----$400

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 Liabilities Assets Stall Van Cash

Loan

Capital 600 550 1,220 ----$2,370

=

Capital b/f Capital introduced

1,220 200

+

400 Creditor 550

----$1,420 ----$950

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

Answer 7c: Credit transactions Liabilities Capital

Assets Stall Van Receivable Cash (1,220-250)

600 550 320 970 ----$2,440

=

Capital b/f Capital introduced Profit from Viv (320-250)

Loan 1,220 200 70 ----$1,490

+

400 Creditor 550

----$950

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 Liabilities Loan

Assets Stall Goods Van Receivable Cash (970-550)

Capital 600 650 550 320 420 ----$2,540

=

Capital b/f Capital introduced Profit from Viv

400 Payable for van 1,220 200 70 ----$1,490

+

550 Payable for goods 100

----$1,050

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 Liabilities Loan 400 Payable for van

Assets

Capital

Stall 600 Van 550 Receivable 320 Cash (420+1,050-50 -200) 1,220 ----$2,690

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

=

----$1,637

+

550 Payable for goods 100 Interest payable 3

----$1,053

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

Debit:

Credit:

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

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

Means left hand side

Means right hand side

Discussion Explain 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 present CR assets (cash) and DR capital by $50. (d) A business sells goods costing $300 at a profit of $140 DR 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 $270 CR 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 loss B $400 loss C $400 profit D $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 loss C $400 profit D $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 loss B $4,500 loss C $4,500 profit D $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 loss B $4,500 loss (54,200 – 47,100 -22,000 + 200*52) C $4,500 profit D $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 $7,500 B $8,500 C $9,500 D $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 $7,500 B $8,500 (25,000 – 15,000 -2,500 + 1,000) C $9,500 D $11,500

QB 3

Answer: C