Chapter 2: The Accounting Equation and Double Entry Flashcards
1.1 intro to financial statements (summary for users to evaluate company’s financial performance. 2 types - SFP and SPL = …
Statement of Financial Position (SFP)
Statement of Profit or Loss (SPL).
1.1.3 Statement of Financial Position (SFP)
is a snapshot of a business’s financial position at a point in time.
The SFP details the business’s assets, liabilities, and capital at a specific date.
ELEMENTS = Assets, Liabilities, Capital
Statement of Profit or Loss (SPL)
is a summary of the performance of a business, highlighting profits or losses that have been generated over a period (usually a year).
The SPL calculates the profit or loss during a year by subtracting business expenditures from business income.
Income - expenditures
Statement of Comprehensive Income (SCI)
The Statement of Comprehensive Income (SCI) is the Statement of Profit or Loss plus any other comprehensive income.
Other comprehensive income includes unrealised gains or losses of foreign currency translations and financial instruments.
Definition of an ASSET
An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Resource controlled means that the entity can control benefits from the asset.
There must be a past event that resulted in the control of the resource. This means that assets are recorded only when the event to control the assets takes place.
Future economic benefit inflow is the probability of a rise in economic benefit such as monetary gains (this may be income or cost savings).
CURRENT Asset
Expected to be used up, sold or collected in a short period (less than a year)
Converts to cash easily
eg Inventory; Trade receivables; money owned by customers; Cash and bank
NON-CURRENT Asset
Expected to be used by a business over several years.
Does not convert to cash easily
Eg. Buildings; motor vehicles; equipment and machinery
LIABILITIES - definition
Generally, a liability is an amount that is owed by the business. A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in a probable outflow of economic benefits.
A present obligation results in a legally enforceable rule. There is a duty or responsibility that the entity has no practical ability to avoid and must be fulfilled.
There must have been a past event that resulted in the obligation arising. This means that liabilities are recorded only when the event for obligation takes place.
Future economic benefit outflow is the probability of a decrease in economic benefit such as monetary losses (this can be in the form of expense or cash leaving the business).
CURRENT Liability
Liabilities which are due for payment in a short period (within one year)
EG. Trade Payables (money owed to suppliers)
Bank Overdraft (bank balance in negative position)
Tax Liabilities (money owed to tax authorities)
NON-CURRENT LIABILITY
Liabilities which are not due for payment within one year
Eg.Bank Loans (repayable over more than 1 year)
Other long-term borrowings
CAPITAL - definition
is the net assets of a business. Net assets are the difference between assets and liabilities.
CAPITAL = ASSETS − LIABILITIES
As the business generates sales, it will likely make profits. The business profits belong to the owners and make up part of the capital until they are withdrawn.
Capital is a particular type of liability – it is special because capital is due to the owners, not to external organisations such as suppliers or banks.
Income can be divided into Revenue and Gains
REVENUE =
Revenue is income generated from ordinary business activities, also known as trading activities. For example:
Sales of goods for a retail business
Rental income received for renting properties
GAINS =
are additional income received for irregular (‘one-off’) transactions.
Businesses may occasionally sell an item that is not in their usual inventory. This is known as an irregular transaction.
For example, Rajiv sells RFashion’s old delivery van so the business can buy a larger one. If the sale results in a higher price than the carrying amount of the asset (recorded value in business recorded), then a gain is made.
Expenditure divided into asset expenditure and expenses.
Expenses =
Expenses are the day-to-day costs of running a business
eg.
Rental payment for premises
Gas and electricity payment for office
Wages to employees
Stationery expenses
Costs of repairing & maintaining a non-current asset. (this is a regular expenditure)
Asset expenditure =
is the purchase of non-current assets.
These are assets bought by a business to be used for more than 12 months. For example:
Shops and buildings
Machinery and vehicles
The cost incurred for improving a non-current asset (one-off expenditure) is also categorised as asset expenditure such as:
Office renovation
Overhaul of vehicle
The ACCOUNTING EQUATION** states that the total value of assets of a business is the sum of the total value of the business’s liabilities plus capital: ASSETS = LIABILITIES + CAPITAL
In other words:
Amount a business owns (Assets) - Amount a business owes (Liabilities) = Amount owed to the owners (Capital)
For example, if a business has assets worth $25,000 and liabilities of $15,000, then the capital belonging to the owners may be calculated: $25,000 - $15,000 = $10,000. The owners have $10,000 of capital in the business.
The effect of every transaction is to either increase or decrease the assets, liabilities, or capital of a business. To record the transactions in ledger accounts, double entries are used. (Section 4)
DOUBLE-ENTRY Bookkeeping
Financial transactions are entered into the general ledger accounts using double-entry bookkeeping.
Every financial transaction gives rise to two accounting entries, a debit and a credit entry, in different ledger accounts. The total debit value always equals the total credit value in the ledger accounts at any time.
EXPANDED ACCOUNTING EQUATION
Capital belongs to the business owner. Capital can also be calculated by the amount the owner invested minus any money that owners have taken out of the business (drawings) plus profit made.
Owner’s Capital = Capital Invested – Drawings + Profits
Profits made by the business are the outcome of Income after deducting all business Expenses/ Expenditure:
Profits = Income – Expenditure
**Assets – Liabilities = Capital Invested – Drawings + Income – Expenditure
or The equation can be rearranged to show only positive signs:
Assets + Drawings + Expenses = Capital + Liabilities + Income
Rules of double entry to account group
There are 5 types of accounts in the Double-Entry system which are: Assets, Liabilities, Capital, Income and Expenses
The accounting equation is used to understand which Accounts to Debit and Credit. The expanded accounting equation is:
ASSETS + DRAWINGS + EXPENSES = CAPITAL + LIABILITIES + INCOME
The items on the left-hand side of the equation are increased by posting a Debit entry. (Assets, Drawings, Expenditure)
The items on the right-hand side of the equation are increased by posting a Credit entry. (Capital, Liabilities, Income)
remember using ‘DEAD CLIC’
‘DEAD; - Debit: Expense, Assets, Drawings examples:
E: Telephone Bill
Rental
Sales Returns
Purchases
A:Motor Vehicles
Bank balance
Inventories
Trade Receivables
Input Sales Tax
D: Drawings
‘CLIC’: Credit. examples
L: Loans
Trade Payables
Output Sales Tax
Bank overdraft
I:Sales
Purchase Returns
Bank Interest received
Discounts received
C:Capital investment
General Ledger and T-Accounts
The general ledger is where all the double entries are recorded. It contains individual accounts for a business’s assets, liabilities, capital, income and expenses. These individual accounts are also known as ledger accounts.
Financial transactions of the business are recorded in the relevant ledger accounts. Immediately, a business can gather information overview such as:
cash balance in the business from the cash ledger account
Sales generated from the sales ledger account.
Double Entries are recorded into the ledger accounts T-Accounts. A T-Account is a graphical representation of a ledger account.
See photo for diagram of elements of a T-account
