Module 1: The Accounting Equation

Question 1

What is the Accounting Equation?

Answer 1

Assets = Liabilities + Owner’s Equity

Question 2

What is an Asset?

Answer 2

To be considered an asset, an item must:
• Be purchased at a cost that is measurable
• Produce probable economic benefit in the future
• Result from a past event
• Be owned or controlled by the entity

Assets are resources such as:
	• Cash
	• Inventory
	• Equipment (e.g. computers)
owned by the business. 

A business expects that assets will produce benefits in future. It should be able to sell inventory, use equipment to produce products and use cash for investment and new projects.

Question 3

What is the balance sheet?

Answer 3

The balance sheet is the fundamental financial report
in which the accounting equation is presented. It’s essentially an expanded representation of the accounting equation. It shows the financial status of a business at a given point in time.

Question 4

At any given point in time, the value of the company’s assets should_________, that is be equal to the sum of the company’s _________ and ______________.

Answer 4

balance; liabilities; owner’s equity.

Question 5

What is another way to arrange the accounting equation?

Answer 5

Owners’ Equity = Assets – Liabilities.

Question 6

What is Owner’s Equity?

Answer 6

“The residual interest in the assets of an entity that remains after deducting its liabilities.”

• Assets-Liabilities = Owner’s Equity.
• aka the difference between what a business has and what a business owes to others
• Amount that would be left over after a business settles all its obligations
• aka the amount that belongs to the owners of the business

Question 7

What are Liabilities? Give some examples of liabilities.

Answer 7

Generally, a liability must satisfy the following:
• It must impose a probable economic obligation on economic resources in the future
• The obligation has to be to another entity
• The event that created the obligation must have occurred in the past

Liabilities are obligations to pay third parties for resources. e.g. loan from bank, purchases on credit from suppliers. Includes wages payable to staff.

Question 8

The left side of the equation is _____. This is what the business has. The right side is _____ and ______. This is how the business funded acquiring those assets.

Answer 8

Assets; Liabilities; Owner’s Equity.

Question 9

What is the difference between a cash transaction and a non-cash transaction?

Answer 9

In a cash transaction, payment is made at the time of purchase. In a non-cash transaction, purchases can be made on credit and payment is deferred to a later time.

Question 10

What 3 ways can a business fund its activities?

Answer 10

1. Liabilities
2. Owner’s Equity
3. Profits

Question 11

What two elements impact owner’s equity?

Answer 11

1. Capital

2. Profits

Question 12

What can be done with Profits?

Answer 12

• Could be distributed to the owners through dividends, or

- Could be reinvested in the business through the retained earnings account

Question 13

Which parts of the equation are affected by sale of product (and how)?

Answer 13

Sales of products will have the effect of increasing assets (cash paid for product) and increasing owner’s equity (revenue made).

Question 14

What is an Expense?

Answer 14

Expenses represent a decrease in owner’s equity. There is a cost to obtaining or creating products to then sell, this is an expense. This cost will decrease assets and owner’s equity.

Question 15

What accounts might appear under the Liabilities section of the balance sheet?

Answer 15

May include accounts payable, salaries payable, long term debt, sales tax payable, unredeemed gift certificates

Question 16

If you start a business and contribute $50k to get it going, what impact will this have on the accounting equation?

Answer 16

Assets will increase by 50k, owner’s equity will increase by 50k.

Question 17

If you took out a loan of $20k to help start a business, how would this impact the accounting equation?

Answer 17

Assets increase by 20k because the loan provides the business with more cash. Liabilities also increase by 20k because the business now has the obligation to pay back the loan at some point in the future.

Question 18

What will be the impact on the accounting equation if you purchase equipment for a business?

Answer 18

This depends on how it is purchased.

1. Purchased with Cash: assets increase, assets decrease. (Assets increase to reflect the new equipment obtained by the business, but assets will also decrease because cash will have been paid out to the vendor of the equipment.)
2. Purchased on Credit: assets increase, liabilities increase. (Assets will increase to reflect the new equipment obtained, but rather than assets immediately decreasing by the amount of cash paid, liabilities would increase to show the obligation to pay.)

Question 19

What will be the impact on the accounting equation if you purchase inventory for a business?

Answer 19

It will be the same as for the purchase of equipment and depends on how it is purchased.

1. Purchased with Cash: assets increase, assets decrease. (Assets increase to reflect the new equipment obtained by the business, but assets will also decrease because cash will have been paid out to the vendor of the equipment.)
2. Purchased on Credit: assets increase, liabilities increase. (Assets will increase to reflect the new equipment obtained, but rather than assets immediately decreasing by the amount of cash paid, liabilities would increase to show the obligation to pay.)

Question 20

What adjustments are made to the accounting equation to reflect the sale of a product (from inventory) for cash?

Answer 20

1. Assets increase (cash received)
2. Owner’s Equity increases (cash received)
3. Assets Decrease (inventory sold)
4. Owner’s Equity decreases (expense of inventory sold)

NOTE - the amounts for the first 2 adjustments will likely differ from the second 2 because COGS will not be the same as the income received for the sale of them. e.g. COGS $10 per item, price of product when sold to customer $20.

Question 21

You purchase inventory on credit with 30 day payment terms. How will the accounting equation be affected at the time of the purchase?

Answer 21

Assets will increase (inventory purchased), liabilities will increase (money owed).

Question 22

You purchase inventory on credit with 30 day payment terms. How will the accounting equation be affected at the end of the 30 day payment period?

Answer 22

Assets will decrease (money paid), Liabilities will decrease (debt paid off).

Question 23

You sell products to a customer with 30 day credit terms. How will the accounting equation be affected at the time of the sale? Note - use the accrual method.

Answer 23

Assets will increase (accounts receivable), owner’s equity will increase (revenue). Assets decrease (inventory sold), owner’s equity decreases (COGS).

Question 24

You sell products to a customer with 30 day credit terms. How will the accounting equation be affected at the time of receipt of payment? Note - use the accrual method.

Answer 24

Assets will decrease (accounts receivable paid), assets will increase (cash received).

Question 25

Under which part of the equation do accounts receivable fit in?

Answer 25

Accounts receivable are part of assets.

Question 26

What is Deferred Revenue and where is it recorded?

Answer 26

Deferred revenue refers to advance payments a company receives for products or services that are to be delivered or performed in the future. Deferred revenue is recorded as a liability on the balance sheet.

Question 27

What is Accounts Receivable?

Answer 27

Accounts receivable (AR) is the balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. Accounts receivables are listed on the balance sheet as a current asset. AR is any amount of money owed by customers for purchases made on credit.

Question 28

What is the Matching Principle?

Answer 28

Expenses should be recognised in the same period as relevant revenues

Question 29

How do you recognise revenue if you allow a customer to purchase on credit with 30 days to pay?

Answer 29

Depends on accounting method. If you use the cash method, you record the transaction when cashes changes hands i.e. when the customer pays after 30 days. If using accrual, you record when the goods are delivered to the customer.

Question 30

What is the Realisation Principle?

Answer 30

Under accrual accounting, you recognise revenues when they are earned and realisable. This means you can recognise revenue even if you haven’t received the cash because you’ve performed the work and can reasonably expect to receive the cash. I.e Revenue can only be recognised once it has been earned.

Question 31

What happens if you are sell products to a customer with credit terms, but you are aware that they have been struggling to pay their invoices recently? How do you recognise the revenue?

Answer 31

If a you have doubts about receiving cash or about the customer’s ability to pay then you shouldn’t recognise revenue.

Question 32

How do you recognise revenue associated with payments made in advance? i.e. a customer pays $200 in January for 6 months of yoga classes.

Answer 32

Revenue should be recognised evenly throughout the year even if the cash is received up front at the start of the year. You can recognise revenue when the services are received because the money is given with an obligation to provide services, alternatively you can recognise an equal amount each month to reflect the benefit the customer has had for that month.

Question 33

When a customer has paid in advance for services (for example), what is the effect on the accounting equation?

Answer 33

Assets increase but so do liabilities (in the form of deferred revenue). This is because we can’t recognise the revenue yet, instead we recognise that we have a liability to provide services/products to this customer before we can recognise the associated revenue.

Question 34

When a customer has paid in advance for services, for example, what adjustments are made over the relevant period as the customer enjoys the benefits of those services?

Answer 34

Over the time period of the prepayment the revenue is moved from liabilities to owner’s equity as/when the customer enjoys the benefit purchase (similar to ‘delivery’). In the case of a service like 6 months of yoga classes, this would be done each month as the customer has enjoyed a month’s benefit. You recognise evenly throughout the year, not specifically when the customer takes as class. The amount recognised is not linked to the amount of classes actually taken (unless this was the specific kind of pack purchased!). In the case of a gift card, this would occur when the customer uses money on that card.

Question 35

How do you record prepayments you make? E.g. you pay for your website a year in advance, how does the effect the equation?

Answer 35

Prepayments are recorded as assets (in the form of prepaid expenses) and then recorded as a reduction in owner’s equity and assets over the relevant time period as the benefit is received. The accrual method spreads this expense over the entire time the service is received.

Practically:
Assets go up and down equally when you prepay, then each month you will see a decrease in owner’s equity pro rata for the month, and a decrease in assets by the same amount.

Why?
You record a decrease in assets initially for cash paid but the an increase in assets representing the right to receive membership benefits for the coming 12 months. Each month you recognise a decrease in assets, because you’ve reduced your right to receive membership benefits by the relevant month ‘used’, and you recognise a decrease in owner’s equity for the pro rata amount of expense recognised.

Question 36

Suppose you buy a subscription to receive financial advice each month. The fees for these subscriptions are $120 for a 12-month subscription, and a youpaid for the full year on January 1st. How will you record this transaction at the time of purchase?

How will you record the transaction after one month?

Answer 36

When thesubscriptionfees are paid, youincrease assets(prepaid expense) by$120. The prepaid expense is an asset because it will provide a benefit in the future (advice that will be received). The payment alsodecreases assets(cash) by$120because the subscription was paid for with cash.

After one month, there is adecrease in assets(prepaid expense) of$10, as one month’s worth ofsubscriptionbenefits are used up (one month’s worth of advice was received). You also recognise one month’s worth of expense, which means there is adecrease in owners’ equityof$10.

Question 37

What are the two main accounting standards in the world?

Answer 37

US GAAP (used mainly in the USA) and the IFRS (used by many countries worldwide).

Question 38

What is the Conservatism Principle? What is its main aim?

Answer 38

Companies must anticipate and record future losses but NOT future gains.

Aimed to keep business managers from using discretion to report overly optimistic numbers in their reports - these will influence financial decisions of outside investors who would be negatively impacted if the business fails in achieving these anticipated numbers.

Question 39

What 2 principles guide the use of sources for accounting information? Give a brief description of each principle.

Answer 39

1. Relevance
   a. Useful, capable of influencing the decision of the users of the financial statement. In e.g. above this would directly effect apples sales as users may use it to make decisions which will effect sales.
   
   2. Reliability
      a. Info faithfully represents the underlying economics
      b. Must faithfully represent the underlying trasnactions it intends to represent
      c. Must be valid
      d. Must be verifiable
      e. Must be unbiased

Question 40

What is Historical Cost? When is it relevant?

Answer 40

Historical Cost refers to the concept that transactions are recorded at the actual price that existed at the time of the transaction, rather than at the price that may be in the market at the time an adjustment/record is being made. The historical number tends to be more reliable, because it tracks back to the actual amount that changed hands.

The use of this varies from GAAP to IFRS. In IFRS you have more freedom to use market value. Under GAAP you have to use Historical.

Note that this is not black and white, it can depend on context and other relevant factors.

Question 41

You have two pieces of land. One was purchased for 100k and has increased in value to 200k. The other was purchased for 100k and has decreased in value to 70k. What values can be used in your financial recording?

Answer 41

Under GAAP: Likely that for the first piece of land, you use the original value of 100k due to the Historical Cost principle. For the second, you would likely the lower value of 70k due to the Conservatism Principle.

Under IFRS: you could likely write the first up to its current value, and write the second down to its current value.

Question 42

What is the Consistency Principle?

Answer 42

The Consistency Principle is that you should use the same underlying assumptions in reporting from one period to the next unless you have a good justification for making a change.

Question 43

What is Materiality? What level of detail is required in reporting?

Answer 43

Means that a piece of information, for example, is reasonably likely to impact decision making of those using accounting data/financial reports. You only need to report at a ‘reasonable’ level of detail. Info can be combined if it doesn’t really make sense to report it individually e.g. you might combine all marketing and PR expenses into one item rather than showing individual expenses.

Companies are only required to keep detailed records and reporting for material items, not trivial ones. E.g. small costs on marketing promotions would not necessarily need to be reported. Note: this depends on the context of the entire financial statement. E.g. $400 may be material for a tiny business, but not for apple.

Question 44

What is the Entity Concept? How does it apply to large multinational and subsidiary companies?

Answer 44

The books of a business are kept separately from the books of individuals, even if there is only one owner of the business. This is called the entity concept. A business is a distinct, separately identifiable entity.

In relation to large multinationals, the highest consolidated level of the company will keep records for those bodies consolidated into it. In the case of subsidiaries though, each subsidiary must keep their own financial records to manage business and prepare tax returns in the countries in which they operate. Therefore there will be two levels of reporting: the local level for each subsidiary and the higher level for the consolidated company.

Question 45

What is the Money Measurement Principle?

Answer 45

Only values that can be measured in monetary terms can be recorded in financial statements - linked to the need for reliability and historical cost principle. Events and circumstances that could have an impact can’t be recorded unless they can be reliably measured in monetary terms and they relate to a historical transaction that has actually occurred. E.g. business has a great relationship with the government but while these are of value, it’s difficult to quantify them. Can’t record as an asset as a result.

Question 46

What is a going concern?

Answer 46

Refers to fact the business will continue to operate in the foreseeable future. Assets will continue to be used for purpose acquired and liabilities to be settled.

Unless you have significant evidence to suggest otherwise we presume a business is a going concern. This allows accrual accounting - otherwise assets don’t have future value and liabilities can’t be settled.

Question 47

What is Revenue?

Answer 47

Iinflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.”

i.e. the money that a business receives from providing goods or services to a customer.

Question 48

What is required to recognise revenue?

Answer 48

To recognise revenue:

• Must be related to the entity’s ongoing major or central operations
• Must be earned (service/product actually delivered to customer)
• must be realisable (cash paid for it or confident the customer can pay for it in future)
• must have an arrangement with the customer that specifies the amount that will be transferred for the good or service

Question 49

What are expenses? When are they recognised?

Answer 49

“Outflows or other using up of assets or incurrence of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.”

i.e. the costs associated with providing goods or services to a customer.

Generally recognized in the period in which the revenues that they help generate are recognized.