Unit 1 The Accounting Equation

Unit 1 : The Accounting Equation1-1. Assets1-2. Liabilities1-3. Owner’s Equity 1-4. Expenses1-5. Revenue1-6. Net Income versus Net Loss1-7. Effects on the Accounting Equation1-8. Solving for a variable1-9. Financial Position1-10. Defining Accounting

The Accounting Equation

The Accounting equation

» Accounting as a whole is based on a single equation:

ASSETS = EQUITY + LIABILITIES

equation

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

Double entry

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

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

Examples of 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.

So what does the accounting equation mean?

» 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

1-1 Assets

What is an asset?

» Official 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.

In other words…

» 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.

Examples

» Land» Computer» Vehicle» Cash

Debtors

» 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.

Are debtors an asset?

» 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.

Measurable value

» 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.

So the full test of whether something is an asset is:

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

THE FUTURE?3. CAN YOU VALUE IT ACCURATELY?

How to value an asset

» 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.

Changes in assets

Increase Assets Decrease Assets

Purchasing Equipment (The asset account Equipment increases)

Purchasing Equipment (The asset account Cash decreases)

Owner Contributions Owner Draws

Receiving bank loans Repaying bank loans

1-2 Liabilities

What is a liability?

» 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.

In other words…

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

leaving the business in the future.

Examples

» 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.

Changes in Liabilities

Increase Liabilities Decrease Liabilities

Receiving a bank loan Repaying a bank loan

Credit purchases Credit Payments

Notes payable to creditors Paying Creditors

1-3 Owner’s Equity

What is Owner’s Equity

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

In other words…

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

Owner’s equity

» 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

ASSETS = EQUITY + LIABILITIES» Assets can only ‘belong’ to two types of people:˃ people outside the business who are owed money

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

Shareholder’s equity

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

Changes in Owner’s Equity

Increase Owner’s Equity Decrease Owner’s Equity

Revenues Expenses

Gains Losses

Owner contributions Owner withdraws

Beginning Capital

Expenses

» The costs the company incurs in carrying on operations in its effort to make money

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

Expenses vs. equipment

» The difference between expenses and equipment is equipment can be liquidated or converted to cash.

» Equipment is an asset (future benefits)» Expenses are used up FAST.» EXAMPLE:

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

Revenues

» Income» Example: a service company earns revenue

when it provides services to its clients» Recorded as an increase in owner’s equity and

an increase in assets˃ Increases Cash OR˃ Increase sDebtors

» Investopedia Explains Revenues`

1-6 Net Income vs.

Net Loss

» 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˃ Revenues = Expenses

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.

1-7 Effects on the Accounting Equation

» Every transaction affects TWO or more accounts!

» This is how the accounting equation stays in balance

For each of the transactions, indicate the two (or more) effects on the accounting equation of the business or company.

The owner invests personal cash in the business.

Assets: Increase Decrease No EffectLiabilities: Increase Decrease No EffectOwner's (or Stockholders') Equity:

Increase Decrease No Effect

The owner withdraws business assets for personal use.

The company receives cash from a bank loan.

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

The company purchases equipment with its cash.

The owner contributes her personal truck to the business

The company purchases a significant amount of equipment on credit.

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

The company pays a bill for telephone services using cash.

The company pays cash for a warehouse.

The company receives a bill for electric services to be paid next month.

The company pays $200 cash for an ad in a local newspaper.

The company purchases technology equipment on credit.

The company receives cash for services rendered.

The company performs services on account.

Which of the following will cause owner’s equity to increase?

a) Expensesb) Owner drawsc) Revenues

Which of the following will cause owner’s equity to decrease?

a) Net incomeb) Net lossc) revenues

The accounting equation should remain in balance because every transaction affects how many accounts?

a) Only oneb) Only twoc) Two or more

1-9 Financial Position

Financial Position

» Analysis of the accounting equation˃ A = E + L

» What % of the assets are actually owned by the owners (equity) versus what % is owed to someone else (liabilities)

Using Percentages

» % part or equity or liabilities whole assets assets

Example:$100,000- assets $60,000- equity $60,000/100,000 = 60% $40,000- liabilities $40,000/100,000 = 40%» This company has a good financial position. It’s

equity is 60% of its assets.

Financial Position Ratings

» Good- Equity is higher than liabilities.» Fair- The company has more debt than equity,

but it is able to pay off its debt.» Poor- Assets will be used to pay off debts, net

worth is not entirely valuable. Liabilities are 75% or higher.

» Terrible- Debts are greater than assets, so the company is making a loss and might have to pay out of pocket to pay off liabilities.

Insolvent

» Debts > Assets » Not enough money to pay off debts = making a

loss»

» Liabilities = ___%˃ 90%

» Financial Position is˃ Poor

» I would not invest

» Liabilities = ___%˃ 120

» Financial Position is˃ Terrible

» This company does not have enough $ to pay off its debts, which means it is ___________.˃ Insolvent

» I would definitely not invest.

» Equity = ___%˃ 60%

» Financial Position is˃ Good

» I would invest

» A = E + L˃ A= $1,100,000 ˃ E= $1,100,000˃ L= $0

» Equity is 100% of the total assets. This company has an excellent financial position. I would invest.

» A = E + L˃ A= $1,140,000˃ E= $640,000 ˃ L= $500,000

» Equity is 56% of the total assets. This company’s financial position is good. I would invest.

» A = E + L˃ A= $2,700,000˃ E= $800,000 ˃ L= $1,900,000

» 70% of the company’s assets are liabilities. This company’s financial position is fair. I might invest depending on other factors.

» A = E + L˃ A= $3,000,000 ˃ E= $-500,000˃ L= $3,500,000

This company’s financial position is terrible. The company is insolvent. It can not pay its debts. I would definitely not invest.

» Create three scenarios˃ One where the company’s financial position is good˃ One where the company’s financial position is fair˃ One where the company’s financial position is poor

Unit 1 Practice Quiz

» Go to http://www.accounting-basics-for-students.com/basic-accounting-test.html and take the practice quiz.

» Make sure you record your answers on a separate sheet of paper as you go.

Unit 1 The Accounting Equation

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