Chapter 2: The Accounting Equation and Double Entry

Question 1

1.1 intro to financial statements (summary for users to evaluate company’s financial performance. 2 types - SFP and SPL = …

Answer 1

Statement of Financial Position (SFP)
Statement of Profit or Loss (SPL).

Question 2

1.1.3 Statement of Financial Position (SFP)

Answer 2

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

Question 3

Statement of Profit or Loss (SPL)

Answer 3

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

Question 4

Statement of Comprehensive Income (SCI)

Answer 4

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.

Question 5

Definition of an ASSET

Answer 5

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).

Question 6

CURRENT Asset

Answer 6

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

Question 7

NON-CURRENT Asset

Answer 7

Expected to be used by a business over several years.
Does not convert to cash easily

Eg. Buildings; motor vehicles; equipment and machinery

Question 8

LIABILITIES - definition

Answer 8

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).

Question 9

CURRENT Liability

Answer 9

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)

Question 10

NON-CURRENT LIABILITY

Answer 10

Liabilities which are not due for payment within one year

Eg.Bank Loans (repayable over more than 1 year)
Other long-term borrowings

Question 11

CAPITAL - definition

Answer 11

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.

Question 12

Income can be divided into Revenue and Gains
REVENUE =

Answer 12

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

Question 13

GAINS =

Answer 13

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.

Question 14

Expenditure divided into asset expenditure and expenses.
Expenses =

Answer 14

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)

Question 15

Asset expenditure =

Answer 15

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

Question 16

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

Answer 16

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)

Question 17

DOUBLE-ENTRY Bookkeeping

Answer 17

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.

Question 18

EXPANDED ACCOUNTING EQUATION

Answer 18

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

Question 19

Rules of double entry to account group

Answer 19

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’

Question 20

‘DEAD; - Debit: Expense, Assets, Drawings examples:

Answer 20

E: Telephone Bill
Rental
Sales Returns
Purchases

A:Motor Vehicles
Bank balance
Inventories
Trade Receivables
Input Sales Tax

D: Drawings

Question 21

‘CLIC’: Credit. examples

Answer 21

L: Loans
Trade Payables
Output Sales Tax
Bank overdraft
I:Sales
Purchase Returns
Bank Interest received
Discounts received
C:Capital investment

Question 22

General Ledger and T-Accounts

Answer 22

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