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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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, $3,000
+$23,000
Note: The business is not GST registered and therefore there are no GST implications in this illustration.
© Mary Low

10. 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, $9,000
$9,000
Total:
$32,000
© Mary Low

11. 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, $9,000
$9,000
$23,000
Trans 3:
- $3,000
New bal.
$17, $3, $9,000
Total:
$29,000 ≠
$32,000
© Mary Low

12. 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, $9,000
$9,000
$23,000
Trans 3:
- $3,000
New bal.
$17, $3, $9,000
$20,000
Total:
$29,000
© Mary Low

13. 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, $3, $9,000
$9,000
$20,000
Trans 4:
+$1,000
New bal.
$18, $3, $9,000
Total:
$30,000 ≠
$29,000
© Mary Low

14. 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

15. 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, $3, $9,000
$9,000
$20,000
Trans 4:
+$1,000
New bal.
$18, $3, $9,000
$21,000
Total:
$30,000
© Mary Low

16. 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, $3, $9,000
$9,000
$21,000
Trans 5:
+ $500
+$500
New bal.
$18, $ $3, $9,000
$21,500
Total:
$30,500
© Mary Low

17. 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, $ $3, $9,000
$9,000
$21,500
Trans 6:
-$3,000
- $3,000
New bal.
$15, $ $3, $9,000
$6,000
Total:
$27,500
© Mary Low

18. 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, $ $3, $9,000
$6,000
$21,500
Trans 7:
+ $ $100
New bal.
$15, $ $3, $9,000
Total:
$27,500
© Mary Low

19. 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, $ $3, $9,000
$6,000
$21,500
Trans 8:
- $1,000
-$1,000
New bal.
$14, $ $3, $9,000
$20,500
Total:
$26,500
© Mary Low

20. 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, $ $3, $9,000
$6,000
$20,500
Trans 9:
- $200
New bal.
$13, $ $3, $9,000
$20,300
Total:
$26,300
© Mary Low

21. 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, $ $3, $9,000
$6,000
$20,300
Trans 10:
+ $50
+ $50
New bal.
$13, $ $3, $9,000
$20,350
Total:
$26,350
© Mary Low

22. 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

23. 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