Accounting Equation (Periodic Inventory System) Hamilton Stationery Shop Mary Low Waikato Management School The University of Waikato © Mary Low

The framework The accounting equation can be said to the framework for the entire accounting process. The accounting equation is an essential building block of accounting. The accounting equation is the basis of all accounting systems. The accounting equation can be used to illustrate simply the double entry system of accounting. The two sides of the equation must be equal. The accounting equation is also called the balance sheet equation. © Mary Low

The basic elements The two basic elements of any organisation are what it owns and what it owes. What it owns are the organisation’s economic resources. These economic resources are used to help the organisation generate revenues. In accounting, these economic resources are called ASSETS. Examples of assets for an organisation are: Cash Inventory Accounts Receivable Land & Buildings Motor Vehicle Furniture & Equipment © Mary Low

The basic elements – what it owes What it owes are the organisation’s sources of financing for the economic resources. The main source of financing usually comes from EQUITY. Equity indicates the amount of financing provided by owners of the organisation. Examples of equity for an organisation are: Owner’s Equity / Proprietorship for a sole trader business Partnership Funds for a partnership business Shareholders Equity for a company business The next source of financing comes from debt. Debt is the result of the organisation purchasing goods, services or assets on credit. Debt also results from loan borrowings. Debt is given the term LIABILITIES. Examples of liabilities for an organisation are: Accounts Payable Loan Payable © Mary Low

The accounting equation what it owns = what it owes Assets = Liabilities + Equity A Balance Sheet (Statement of Financial Position) shows that the assets of an organisation should equal to its liabilities plus equity. This is why the accounting equation is also called a balance sheet equation. © Mary Low

Different versions of the accounting equation The accounting equation can be expressed in a number of different ways: Asset emphasis: Assets = Liabilities + Equity Liability emphasis: Liabilities = Assets – Equity Equity emphasis: Equity = Assets - Liabilities © Mary Low

Running a business - its main objective Businesses usually operate with the objective of making a profit. Profit is determined by looking at two other elements. These financial elements relate to revenue (income) and expenses Profit is determined by subtracting expenses from revenues i.e. Profit = Revenue (Income) - Expenses © Mary Low

Profit Any profits made by a business will go to the owner. Therefore, revenue (income) and expenses effects are usually shown under the Equity section of the accounting equation. An increase in revenues (income) represents an increase in profit and therefore an increase in Equity. An increase in expenses represents a decrease in profits and therefore a decrease in Equity. © Mary Low

Transaction 1 Transaction 1: Investment by owner. Ray Comic decides to open a stationery shop in Hamilton by investing $20,000 cash and $3,000 of inventory into the business. The transaction results in an increase in the Cash and Inventory Assets and an increase in Equity. We note that the equation remains in balance, i.e. A = L + OE Assets = Liabilities + Owner’s Equity Cash + Inventory Capital +$20,000 + $3,000 +$23,000 Note: The business is not GST registered and therefore there are no GST implications in this illustration. © Mary Low

Transaction 2 Assets = Liabilities + Owner’s Equity Old bal. Transaction 2: Purchase of equipment on credit. Comic purchases equipment on credit from Waikato Equipment Ltd for $9,000 (credit terms: 180 days). The transaction results in an increase in the Equipment Asset and an increase in Liability. We note that the equation remains in balance, i.e. A = L + OE Assets = Liabilities + Owner’s Equity Cash + Inventory + Equipment Accounts Payable Capital Old bal. $20,000 + $3,000 $23,000 Trans 2: + $9,000 +$9,000 New bal. $20,000 + $3,000 + $9,000 $9,000 Total: $32,000 © Mary Low

Transaction 3 Transaction 3: Purchase of stationery inventory for resale. Comic purchases stationery for resale using $3,000 cash from the business. The transaction results in an increase in Purchases Expense and a decrease in the Cash Asset. We note that the equation does not have an Expense heading, i.e. the equation is given as: A = L + OE Assets = Liabilities + Owner’s Equity Cash + Inventory + Equipment Accounts Payable Capital Old bal. $20,000 + $3,000 + $9,000 $9,000 $23,000 Trans 3: - $3,000 New bal. $17,000 + $3,000 + $9,000 Total: $29,000 ≠ $32,000 © Mary Low

Note: Where we do not have a separate expense heading in the accounting equation, expenses will need to be deducted from Capital. Because we are recording the purchase of goods (inventory) for resale as an expense, we therefore need to record this as a deduction from Capital. The equation is now in balance. Assets = Liabilities + Owner’s Equity Cash + Inventory + Equipment Accounts Payable Capital Old bal. $20,000 + $9,000 $9,000 $23,000 Trans 3: - $3,000 New bal. $17,000 + $3,000 + $9,000 $20,000 Total: $29,000 © Mary Low

Transaction 4 Assets = Liabilities + Owner’s Equity Transaction 4: Cash sales of stationery. Comic earns cash sales of stationery items for $1,000. We can straight away see that the transaction results in an increase in the Cash Asset by $1,000 and an increase in the Sales Revenue (Income) account by $1,000. We note that the equation does not have Revenue (Income) heading, i.e. the equation is given as: A = L + OE We note that the equation will not balance at this stage. Assets = Liabilities + Owner’s Equity Cash + Inventory + Equipment Accounts Payable Capital Old bal. $17,000 + $3,000 + $9,000 $9,000 $20,000 Trans 4: +$1,000 New bal. $18,000 + $3,000 + $9,000 Total: $30,000 ≠ $29,000 © Mary Low

What have we missed out? Cash sales represents revenue (income) being earned by Hamilton Stationery Shop. This is another financial element in the accounting process. A business essentially operates to make profits. Profits for a business are determined by subtracting expenses from revenues (Income). Expenses are the costs of operating a business and are usually incurred as a result of generating revenues (income) for the business. Expenses are also a financial element of the accounting process. Cash sales of $1,000 represent $1,000 increase in Cash Asset as well as $1,000 increase in Sales Revenue. This $1,000 in Sales Revenue (Income) has to be added to Equity. © Mary Low

Completion To complete the accounting equation for transaction 4, we need to show the Sales Revenue of $1,000 effect under Equity. We note that the equation is now in balance, i.e. A = L + OE Assets = Liabilities + Owner’s Equity Cash + Inventory + Equipment Accounts Payable Capital Old bal. $17,000 + $3,000 + $9,000 $9,000 $20,000 Trans 4: +$1,000 New bal. $18,000 + $3,000 + $9,000 $21,000 Total: $30,000 © Mary Low

Transaction 5 Transaction 5: Credit sales of stationery. Comic sells stationery items for $500 on credit to B. Worm. The transaction results in an increase in an Account Receivable Asset by $500. B. Worm owes $500 to Hamilton Stationery Shop. He is an Account Receivable and therefore recorded as an asset to the business. Although no cash has been received from this sale, $500 Sales Revenue have been earned (Accrual concept) and will increase Equity. Assets = Liabilities + Owner’s Equity Cash + Accounts Receivable + Inventory +Equipment Accounts Payable Capital Old bal. $18,000 + $3,000 + $9,000 $9,000 $21,000 Trans 5: + $500 +$500 New bal. $18,000 + $500 + $3,000 + $9,000 $21,500 Total: $30,500 © Mary Low

Transaction 6 Transaction 6: Paid Accounts Payable. Comic makes a $3,000 partial debt repayment to Waikato Equipment Ltd. The transaction results in a decrease to Cash Asset and a decrease to Accounts Payable Liability. Assets = Liabilities + Owner’s Equity Cash + Accounts Receivable + Inventory +Equipment Accounts Payable Capital Old bal. $18,000 + $500 + $3,000 + $9,000 $9,000 $21,500 Trans 6: -$3,000 - $3,000 New bal. $15,000 + $500 + $3,000 + $9,000 $6,000 Total: $27,500 © Mary Low

Transaction 7 Transaction 7: Received money owing from Accounts Receivable. B. Worm pays $100 on account owing to Hamilton Stationery Shop. The transaction results in an increase to Cash Asset and a decrease to the Accounts Receivable Asset. Assets = Liabilities + Owner’s Equity Cash + Accounts Receivable + Inventory +Equipment Accounts Payable Capital Old bal. $15,000 + $500 + $3,000 + $9,000 $6,000 $21,500 Trans 7: + $100 - $100 New bal. $15,100 + $400 + $3,000 + $9,000 Total: $27,500 © Mary Low

Transaction 8 Transaction 8: Drawings by Ray Comic. Ray decides to take $1,000 cash from the business for his personal use. The transaction results in a decrease to Cash Asset and a decrease to Capital Equity. Any withdrawals of assets by the owner from his business for his personal use will cause a decrease in his investment in the business. Assets = Liabilities + Owner’s Equity Cash + Accounts Receivable + Inventory +Equipment Accounts Payable Capital Old bal. $15,100 + $400 + $3,000 + $9,000 $6,000 $21,500 Trans 8: - $1,000 -$1,000 New bal. $14,100 + $400 + $3,000 + $9,000 $20,500 Total: $26,500 © Mary Low

Transaction 9 Transaction 9: Payment of Expense. Comic pays $200 salaries to shop employee. The transaction results in a decrease to Cash Asset and a decrease to Equity because of salaries expense. Assets = Liabilities + Owner’s Equity Cash + Accounts Receivable + Inventory +Equipment Accounts Payable Capital Old bal. $14,100 + $400 + $3,000 + $9,000 $6,000 $20,500 Trans 9: - $200 New bal. $13,900 + $400 + $3,000 + $9,000 $20,300 Total: $26,300 © Mary Low

Transaction 10 Transaction 10: Received interest on bank balance. Hamilton Stationery Shop earned $50 on its Cash at Bank account balance. The transaction results in an increase to Cash Asset and a increase to Equity as a result of interest revenue being earned. We note that the equation has remained in balance, i.e. A = L + OE Assets = Liabilities + Owner’s Equity Cash + Accounts Receivable + Inventory +Equipment Accounts Payable Capital Old bal. $13,900 + $400 + $3,000 + $9,000 $6,000 $20,300 Trans 10: + $50 + $50 New bal. $13,950 + $400 + $3,000 + $9,000 $20,350 Total: $26,350 © Mary Low

Expanded accounting equation The accounting equation can be expanded to include Revenue (Income) and Expenses. We begin with: Assets = Liabilities + Equity We bring in the profit element: Assets = Liabilities + Equity + Profit Note: Profit = Revenue – Expenses Expanded we have: Assets = Liabilities + Equity + Revenue – Expenses Which can also be written as: Assets + Expenses = Liabilities + Equity + Revenue © Mary Low

Transaction Analysis Well, you have done it! The Hamilton Stationery Shop illustration using the accounting equation has shown you how to do the following in the accounting process: Analyse transactions by identifying the accounts its effects on the main financial elements (Assets, Liabilities, Equity, Revenue (Income) and Expenses) of financial statements Showing the effects in the accounting equation and maintaining the equation in balance all the time. This is the initial basis of understanding the double entry system without actually learning the debit and credit rules of the double entry system. This comes next if you truly want to understand the accounting system of any organisation. © Mary Low