The Basic Accounting Equation

Question 1

What is Accounting?

Answer 1

Several definitions

• The recording, analysing and summarising of financial data of an entity.
• The identifying, measuring and communicating of economic information to permit informed judgements and decisions by users of the information.

Question 2

What are the books of prime entry?

Answer 2

The books where transactions are recorded and analysed.

Question 3

What are the ledger accounts?

Answer 3

They are where transactions are posted after having been recorded and analysed in the books of prime entry.

Question 4

What are the financial reports?

Answer 4

Where transactions are summarised.

It is the last step after they have been recorded and analysed in the books of prime entry and posted in the ledger accounts.

Question 5

The accounting process

Answer 5

Question 6

The main elements of financial reports produced by an organisation are:

Answer 6

• Statement of Financial Position
• Income Statement
• Cash Flow Statement

Question 7

What is the Statement of Financial Position?

Answer 7

(balance sheet)

A statement of assets owned and liabilities owed by the business at a certain date

Question 8

What is the Income Statement?

Answer 8

(profit and loss account)

A record of the income earned and expenses incurred over a period of time

Question 9

What is the Cash Flow Statement?

Answer 9

A record of the movement of cash over a period of time

Question 10

What are assets?

Answer 10

Resources owned by a business

• Cash at bank,
• Goods,
• Buildings,
• Vehicles

Question 11

What are liabilities?

Answer 11

Amount owed to third parties (obligations) (Dettes)

• Loans
• owed to supplier
• taxation owed

Question 12

What is Equity ?

Answer 12

The investment that the owner makes and is owed to the owner (A type of liability)

(capitaux/fonds propres, capital)

Question 13

Who are the main users of financial information relating to a business?

Answer 13

Question 14

What are the two Branches of Accounting?

Answer 14

• Financial accounting for external users
• Management accounting for internal users

Question 15

Financial Accounting Vs Management Accounting

Answer 15

Question 16

Equity and Revenue Items :

Answer 16

• Revenue expenditure
• Capital expenditure
• Revenue income
• Capital Income

Question 17

Revenue expenditure=

Answer 17

Purchase of raw material, salaries, rent etc.

Question 18

Capital expenditure =

Answer 18

Purchase of non-current assets e.g. buildings, shop fittings etc.

Question 19

Revenue income =

Answer 19

Proceeds from sale of goods, interest and dividends received

Question 20

Capital Income =

Answer 20

Proceeds from sale of non-current assets e.g. buildings, machinery etc.

Question 21

The Basic Accounting Equation

Answer 21

Assets = Liabilities + Equity

Question 22

What does a Business Entity owns and owes ?

Answer 22

Owns

• Assets – Cash at bank, Goods, Buildings, Vehicles

Owes

• Equity – Amount introduced by owner
• Liability – Loans, owed to supplier, taxation owed

Question 23

Movement in Assets and Liabilities

Answer 23

Question 24

The Income Statement =

Answer 24

The purpose of the income statement (profit and loss account) is to measure and report how much profit or loss the business generated over an accounting period

Question 25

Revenue =

Answer 25

Measure of inflow of economic benefits from ordinary activities

E.g. Sales of goods or services

Question 26

Expenses =

Answer 26

Outflow of economic benefits arising from ordinary activities.

E.g. salaries, rent

Question 27

The extended accounting equation

Answer 27

The basic accounting equation can be extended to incorporate any profit/loss transactions and stated as follows:

Basic Accounting Equation:

Assets = Liabilities + Equity

Extended Accounting Equation:

Assets = Liabilities + Equity + Profits

Assets = Liabilities + Equity + (Revenue–Expenses)

Question 28

Income statement and statement of financial position

Answer 28

Question 29

Example of the layout of an Income Statement

Answer 29

Question 30

Example of the layout of a Statement of Financial Position as at 30 June 2016

Answer 30

Question 31

Income Statement, Three types of profits

Answer 31

Gross profit - represents the profit from buying and selling goods before any other expenses

Operating profit – this is profit after deducting all operating expenses incurred in running the business (e.g. salaries)

Profit before tax - Operating profit is then adjusted for non-operating income/expenses such as finance cost

Question 32

Recording Transactions

Answer 32

Question 33

Debits and Credits

Answer 33

An account either receives or gives

1. Debit means to receive
2. Credit means to give

When a transaction takes place, it is necessary to ask the following two questions:

1. Which account receives – to be debited
2. Which account gives – to be credited

Question 34

ALL Assets and Expenses are =

Answer 34

DEBIT

Question 35

ALL Incomes and Liabilities are =

Answer 35

CREDIT

Question 36

What is the Trial Balance?

Answer 36

• Once all the accounts have been balanced off, a Trial Balance (TB) is extracted
• A TB is a list of all the debit and credit balances from the Nominal Ledger accounts.
• A TB is compiled at the end of a specific accounting period
• The total of the debit balances should equal the total of the credit balances if double-entry book-keeping procedures have been carried out correctly.

Question 37

An Example –
Trial Balance at 30 June 2016

Answer 37

Question 38

A TB confirms that the following have been carried out:

Answer 38

• For every debit entry there appears to be a credit entry – dual aspect concept
• The amount for each debit and credit entry has been entered correctly in appropriate accounts
• The balance on each account has been calculated, extracted and entered correctly in the trial balance
• The debit and credit columns in the trial balance total to the same amount.

Question 39

Errors not disclosed by the Trial Balance :

Answer 39

• Omission – A transaction completely omitted
• Wrong account
• Entered in the wrong account (e.g. purchases instead of stationery)
• Entered in the correct type of account but wrong personal account – Smith’s transaction entered in Jones’ account
• Compensating – identical addition errors in the debit and credit columns of two accounts – one cancelling the other (£90 instead of £900)