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. The actual resources that are in the business are called 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

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 = Capital + Liabilities Cash at bank €40,000 Capital €50,000 Equipment €10,000

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 €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

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 €50,000 Equipment €10,000 Liabilities: Creditors €2,000 Vehicles €15,000 Stock €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 €50,000 Equipment €10,000 Liabilities: Creditors €2,000 Vehicles €15,000 Stock €1,500 €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 €50,000 Equipment €10,000 Liabilities: Creditors €2,000 Vehicles €15,000 Stock €1,200 Debtors €300 €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 €50,000 Equipment €10,000 Liabilities: Creditors €2,000 Vehicles €15,000 Stock €1,200 €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 Capital 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

Example - Henry Spud’s Balance Sheet Transaction After 1 2 3 4 5 6 7 8 Assets: Cash at bank 50,000 40,000 25,000 25,500 25,800 Equipment 10,000 Vehicles 15,000 Stock 2,000 1,500 1,200 Debtors 300 Liabilities: Creditors (15,000) (17,000) (2,000)

Points to Remember 1 Accounting is concerned with the recording and classifying and summarising of data, and then communicating what has been learned from it. 2 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. 3 Accounting information can help the owner(s) of a business to plan for the future. 4 The accounting equation is: Assets = Capital + Liabilities. 5 The totals of each side of the balance sheet should always be equal to each other. 6 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 LEDGER ACCOUNT CREDIT side Date Details Amount Date Details Amount

Double-entry Rules A debit (Dr) represents an asset and a credit (Cr) represents a liability or capital 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. 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. For every transaction a debit will have a corresponding credit and vice versa

Double-entry Rules Assets An increase Debit A decrease Credit Accounts To record Entry in the account Assets An increase Debit A decrease Credit Liabilities Capital

Double-entry Rules Increases + Decreases - Decreases - Increases + 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 Bank Account CR 1Jan Capital a/c 50,000   DR Capital Account CR Bank a/c

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 Bank Account CR 1Jan Capital a/c 50,000 2Jan Equipment a/c 10,000   DR Equipment Account CR Bank a/c

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 Motor Vehicles Account CR 3Jan Bargain City a/c 15,000   DR Creditors Account (Bargain City) CR Vehicles a/c

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 CR 4Jan Food suppliers a/c 2,000   DR Creditors Account (Food Suppliers) CR Stock a/c

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 Creditors Account (Bargain City) CR 5Jan Bank a/c 15,000 3Jan Vehicles a/c   DR Bank Account CR 1Jan Capital a/c 50,000 2Jan Equipment a/c 10,000

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 CR 1Jan Capital a/c 50,000 2Jan Equipment a/c 10,000 6Jan Stock sales a/c 500 5Jan Vehicles a/c 15,000   DR Stock Sales Account CR Bank a/c

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 Debtors Account (John Duncan) CR 7Jan Stock sales a/c 300   DR Stock Sales Account CR 6Jan Bank a/c 500 John Duncan a/c

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 CR 1Jan Capital a/c 50,000 2Jan Equipment a/c 10,000 6Jan Stock sales a/c 500 5Jan Vehicles a/c 15,000 8Jan John Duncan a/c 300   DR Debtors Account (John Duncan) CR 7Jan Bank a/c

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 DR Bank Account CR 1Jan Capital a/c 50,000 2Jan Equipment a/c 10,000 6Jan Stock sales a/c 500 5Jan Vehicles a/c 15,000 8Jan John Duncan 300   Balance c/d 25,800 50,800 DR Bank Account CR 1Jan Capital a/c 50,000 2Jan Equipment a/c 10,000 6Jan Stock sales a/c 500 5Jan Vehicles a/c 15,000 8Jan John Duncan 300   50,800 DR Bank Account CR 1Jan Capital a/c 50,000 2Jan Equipment a/c 10,000 6Jan Stock sales a/c 500 5Jan Vehicles a/c 15,000 8Jan John Duncan 300   Balance c/d 25,800 50,800 DR Bank Account CR 1Jan Capital a/c 50,000 2Jan Equipment a/c 10,000 6Jan Stock sales a/c 500 5Jan Vehicles a/c 15,000 8Jan John Duncan 300   Debit total 50,800 – Credit total 25,000

Example - Henry Spud’s Balance Sheet Opening Balance Sheet Assets:   Cash 50,000 Capital 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

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.