Accounting for Assets and Liabilities Chapter 2

© Luby & O’Donoghue (2005)

The Accounting Equation The resources in the business = The resources supplied by the owner(s)

The Accounting Equation The amount of the resources supplied by the owner is called capital. capital The actual resources that are in the business are called assets. assets Assets = Capital Liabilities represent the amounts owing to people other than the owner(s) in relation to supply of the assets. Assets = Capital + Liabilities

The Accounting Equation Assets = Capital + Liabilities or rearrange to have

Assets - Liabilities = Capital

Business Transactions Day to day business involves many business transactions. A business transactions occurs when there is a transfer of assets/liabilities between the parties of a transaction. As each transaction is processed it has an effect on the accounting equation however, the accounting equation should always remain equal irrespective of the transaction that has occurred.

Example – Henry Spud The following simplified examples are based upon Henry Spud who has started in business selling baked potatoes and other hot foods from a mobile vehicle. He mainly travels to concerts and festival around Ireland however he also caters for private parties. The eight transactions are typical accounting transactions that affect any type of business. The effect on the accounting equation of this business is shown in each.

Transaction 1 - Introduction of Capital The owner (Henry Spud) commences business investing €50,000 which is lodged in a business bank account.

The Accounting Equation – After Transaction 1 Assets = Capital + Liabilities Cash at bank

€50,000 = Capital

€50,000

Transaction 2 - Purchase of an Asset Paying Immediately The business purchases an asset (equipment) costing €10,000 paying for it by cheque.

The Accounting Equation – After Transaction 2 Assets Cash at bank

€40,000

Equipment

€10,000 €50,000

=

Capital + Liabilities Capital

€50,000

€50,000

Transaction 3 - Purchase of an Asset on Credit The business purchases another asset (a vehicle) on credit for €15,000.

The Accounting Equation – After Transaction 3 Assets

=

Capital + Liabilities

Cash at bank

€40,000

Capital

€50,000

Equipment

€10,000

Liabilities: Creditors

€15,000

Vehicles

€15,000 €65,000

€65,000

Transaction 4 - Purchase of Stock on Credit The business purchases the asset of stock on credit for €2,000.

The Accounting Equation – After Transaction 4 Assets

=

Capital + Liabilities

Cash at bank

€40,000

Capital

€50,000

Equipment

€10,000

Liabilities: Creditors

€17,000

Vehicles

€15,000

Stock

€2,000 €67,000

€67,000

Transaction 5 – Payment of a Liability The business decides to pay amounts owing for the original purchase of the vehicle of €15,000 (transaction 3).

The Accounting Equation – After Transaction 5 Assets

= Capital + Liabilities

Cash at bank

€25,000

Capital

Equipment

€10,000

Liabilities: Creditors

Vehicles

€15,000

Stock

€50,000 €2,000

€2,000 €52,000

€52,000

Transaction 6 – Selling Stock for Cash The business sells some stock for €500. Henry has decided that he will sell his produce at cost for the first few weeks thus foregoing a profit just to get a share of the market.

The Accounting Equation – After Transaction 6 Assets

=

Capital + Liabilities

Cash at bank

€25,500

Capital

Equipment

€10,000

Liabilities: Creditors

Vehicles

€15,000

Stock

€50,000 €2,000

€1,500 €52,000

€52,000

Transaction 7 – Selling Stock on Credit In this transaction stock is sold at original cost (no profit) on credit amounting to €300 when Henry catered for a private party. It was agreed that the customer (a friend) could pay him later on in the month.

The Accounting Equation – After Transaction 7 Assets

=

Capital + Liabilities

Cash at bank

€25,500

Capital

Equipment

€10,000

Liabilities: Creditors

Vehicles

€15,000

Stock Debtors

€50,000 €2,000

€1,200 €300 €52,000

€52,000

Transaction 8 – Payment by a Debtor Debtors pay the cash owed by them to Henry by cheque.

The Accounting Equation – After Transaction 8 Assets

= Capital + Liabilities

Cash at bank

€25,800

Capital

Equipment

€10,000

Liabilities: Creditors

Vehicles

€15,000

Stock

€50,000 €2,000

€1,200 €52,000

€52,000

The Balance Sheet The accounting equation is expressed in a financial position statement called the Balance Sheet. It is NOT the first accounting record to be made. It is usually prepared at the end of a financial period.

Example - Henry Spud’s Balance Sheet Opening Balance Sheet Assets: Cash

50,000 50,000

Capital

50,000

Closing Balance Sheet (after 8 transactions) Assets: Cash

25,800

Equipment

10,000

Vehicles

15,000

Stock

1,200

Liabilities: Creditors

(2,000) 50,000

Capital

50,000

Example - Henry Spud’s Balance Sheet Transaction

After

After

After

After

After

After

After

After

1

2

3

4

5

6

7

8

Assets: Cash at bank

50,000

Equipment

40,000

40,000

40,000

25,000

25,500

25,500

25,800

10,000

10,000

10,000

10,000

10,000

10,000

10,000

15,000

15,000

15,000

15,000

15,000

15,000

2,000

2,000

1,500

1,200

1,200

Vehicles Stock Debtors

300

Liabilities: Creditors 50,000

50,000

(15,000)

(17,000)

(2,000)

(2,000)

(2,000)

(2,000)

50,000

50,000

50,000

50,000

50,000

50,000

Points to Remember 1 2

3 4 5 6

Accounting is concerned with the recording and classifying and summarising of data, and then communicating what has been learned from it. It may not only be the owner of a business who will need the accounting information; it may need to be shown to others, e.g. the bank or the Inspector of Taxes. Accounting information can help the owner(s) of a business to plan for the future. The accounting equation is: Assets = Capital + Liabilities. The totals of each side of the balance sheet should always be equal to each other. Every transaction affects two items in the balance sheet.

Double-entry Assets and Liabilities

Double-entry Principle Every business transaction has a twofold aspect Both sides must be recorded The double-entry system has an account for every asset, every liability and capital.

DEBIT side Date Details

LEDGER ACCOUNT

Amount

Date

CREDIT side Details

Amount

Double-entry Rules 1. A debit (Dr) represents an asset and a credit (Cr) represents a liability or capital 2. If a transaction requires you to increase an asset account you debit the asset account with the amount of the increase; to decrease an asset account you credit the asset account. 3. If a transaction requires you to increase a liability or capital account you credit the account with the amount of the increase; to decrease a liability or capital account you debit the capital or liability account. 4. For every transaction a debit will have a corresponding credit and vice versa

Double-entry Rules Accounts

To record

Entry account

Assets

An increase

Debit

A decrease

Credit

An increase

Credit

A decrease

Debit

An increase

Credit

A decrease

Debit

Liabilities

Capital

in

the

Double-entry Rules ASSET ACCOUNTS

Increases +

Decreases -

LIABILITY ACCOUNTS

Decreases -

Increases +

CAPITAL ACCOUNTS

Decreases -

Increases +

A handy rule for remembering double-entry

Debit the Receiver Credit the Giver

Example – Henry Spud The following simplified examples are based upon Henry Spud who has started in business selling baked potatoes and other hot foods from a mobile vehicle. He mainly travels to concerts and festival around Ireland however he also caters for private parties. The eight transactions are typical accounting transactions that affect any type of business. The effect on the accounting equation of this business is shown in each.

Transaction 1 - Introduction of Capital The owner put €50,000 into the business bank account on the 1st January.

DR 1Jan

Capital a/c

DR

Bank Account

CR

50,000

Capital Account 1Jan

CR Bank a/c

50,000

Transaction 2 - Purchase of an Asset Paying Immediately The business purchases an asset (equipment) on the 2nd January, costing €10,000 paying for it by cheque.

DR 1Jan

Capital a/c

DR 2Jan

Bank a/c

Bank Account 50,000

2Jan

CR Equipment a/c

Equipment Account 10,000

10,000

CR

Transaction 3 - Purchase of an Asset on Credit The business purchases another asset (motor vehicles) on credit from Bargain City Motors Ltd for €15,000 on the 3rd January.

DR 3Jan

DR

Motor Vehicles Account Bargain City a/c

CR

15,000

Creditors Account (Bargain City) 3Jan

Vehicles a/c

CR 15,000

Transaction 4 - Purchase of Stock on Credit The business purchases the asset of stock on credit for €2,000 from Food Suppliers Ltd on the 4th January.

DR

Stock Purchases Account

4Jan Food suppliers a/c

DR

CR

2,000

Creditors Account (Food Suppliers) 4Jan

Stock a/c

CR 2,000

Transaction 5 – Payment of a Liability On 5th January the business decides to pay amounts owing for the original purchase of motor vehicles of €15,000 (transaction 3).

DR 5Jan

Creditors Account (Bargain City) Bank a/c

DR 1Jan

15,000 3Jan

Vehicles a/c

Bank Account Capital a/c

50,000 2Jan 5Jan

CR 15,000

CR Equipment a/c

10,000

Vehicles a/c

15,000

Transaction 6 – Selling Stock for Cash On the 6th of January the business sells some stock for €500 receiving the money by cheque.

DR

Bank Account

1Jan

Capital a/c

6Jan

Stock sales a/c

DR

50,000 2Jan 500 5Jan

CR Equipment a/c

10,000

Vehicles a/c

15,000

Stock Sales Account 6Jan

Bank a/c

CR 500

Transaction 7 – Selling Stock on Credit On the 7th January Henry catered for a private party and charged €300 to John Duncan. He performed this service at cost price as John is a friend. He also allowed John to pay him later on in the month. DR 7Jan

DR

Debtors Account (John Duncan) Stock sales a/c

CR

300

Stock Sales Account

CR

6Jan

Bank a/c

500

7Jan

John Duncan a/c

300

Transaction 8 – Payment by a Debtor J Duncan (debtor) pays the cash owed by him to the firm by cheque on the 8th January. DR

Bank Account

1Jan

Capital a/c

6Jan

Stock sales a/c

500 5Jan

8Jan

John Duncan a/c

300

DR 7Jan

50,000 2Jan

CR Equipment a/c

10,000

Vehicles a/c

15,000

Debtors Account (John Duncan) Stock sales a/c

300 8Jan

Bank a/c

CR 300

Balancing Accounts In order to find the figure for the Balance Sheet, an account must be totalled or balanced. This is usually done at the end of an accounting period. The Bank Account would be balanced as follows:

Credit side amounts to 25,000 i.e. 10,000 + 15,000

1Jan 1Jan 6Jan 6Jan 8Jan 8Jan 8Jan

DR DR

Capital a/c Capital a/c Stock sales a/c Stock sales a/c John Duncan Duncan John John Duncan

Bank Account Bank Account 50,000 2Jan Equipment a/c 50,000 2Jan 50,000 2Jan Equipment a/c 500 5Jan Vehicles a/c 500 5Jan 500 5Jan Vehicles a/c 300 300 300 300 Balance c/d 50,800 50,800

Balance c/d

25,800

CR CR 10,000 10,000 15,000 15,000

25,800 50,800

Debit total 50,800 – Credit total 25,000

Example - Henry Spud’s Balance Sheet Opening Balance Sheet Assets: Cash

50,000 50,000

Capital

50,000

Closing Balance Sheet (after 8 transactions) Assets: Cash

25,800

Equipment

10,000

Vehicles

15,000

Stock

1,200

Liabilities: Creditors

(2,000) 50,000

Capital

50,000

Accounting Concepts Accounting concepts are broad basic assumptions, which form the basis of the financial accounts of a business. It is essential that all businesses follow these basic assumptions since they help to ensure that transactions and accounts are recorded and prepared in a uniform manner.

The Business Entity Concept This concept states that the business is separate from the owner. Thus, the items recorded in a firm’s accounting records and books are limited to the transactions that affect the firm and will not concern themselves with the private transactions of the owner. The only transactions between the business and the owner that is recorded in the business records are The owner investing resources (usually cash) in the business. The owner taking out resources (usually cash or stock) from the business for his own use (termed drawings).

The Dual Aspect Concept This concept states that there are two aspects to accounting. One, represented by the assets of the business, and the other by the claims against them (capital and liabilities). This concept states that these two aspects will always be equal.