Download assets = liabilities + equity

Module 3
The process of Accounting & The Balance Sheet
1
The characteristics of
business transactions
 A business transaction is recorded when there has
been an exchange of resources between one business
and another person or business in monetary terms
 The exchange must be at arm’s length.
 Entity concept must be kept intact – i.e. business
records must be kept separate from the owner’s
personal records
 Personal expenditure from the entity’s funds are
known as drawings.

Transactions can be either in cash or credit.
 Source documents provide evidence of the business
transactions.
2
Examples of Source Documents
3
Business transaction
versus a business event
 Personal transactions are ones that do not involve an
exchange between the business entity and another
entity.
 Negotiations between the entity and outsiders will not
be recorded as a business transaction until an
exchange of resources actually takes place.
 Negotiations are considered as simply a business
event:

These must not be included in the entity’s records until a
source document evidences an exchange
of resource/s
4
The accounting equation –
process of double entry
 The accounting equation is known as the
relationship between assets (whether
owned or controlled by the entity)
liabilities and equity
Assets = Liabilities + Equity
 Liabilities and equity represent the claims
against the entity’s assets.
 Business transactions are analysed by
examining the dual effect of each
business transaction and the impact on
the accounting equation
5
Part A: Double entry explained
6
The Accounting Equation
ASSETS
=
LIABILITIES +
(external claims)
OWNER’S EQUITY
(internal claims)
Uses of funds
Sources of funds
Owns/control
Owes
DEBIT (dr)
the left hand side
DEBIT side (dr)
CREDIT (cr)
the right hand side
CREDIT side (cr)
Explain bank statements then!
7
Double Entry (Duality)
DEBIT (dr)
CREDIT (cr)
Business transactions are analysed by examining the dual effect
of each business transaction and the impact on the accounting
equation
Duality means that every business
transaction will affect the accounting
equation – the result of which leaves the
equation in balance! This requires at
least TWO entries (double entry)
Assets = Liabilities + Equity
8
We will be using a
practical example
Teresa and her carpet business
(Handout)
9
Transaction analysis – April 1
Business transactions are analysed by examining the dual effect
of each business transaction and the impact on the accounting
equation
TRANSACTION: Teresa starts business with $20,000 of her own
money and a $50,000 loan from her aunt
Cash $70,000
=
Loan $50,000
(dr)
+
Capital $20,000
(cr)
Duality = at least TWO entries
equation in balance! (double entry)
10
Balance Sheet – April 1
– complete this!
TRANSACTION: Teresa starts business with $20,000 of her own
money and a $50,000 loan from her aunt
Assets
Balance Sheet as at 1 April
Liabilities
Cash
Loan
Equity
Capital
Contributed
Assets =
(dr)
Liabilities + Owner’s Equity
(cr)
11
Double Entry (Duality)
DEBIT (dr)
CREDIT (cr)
the traditional general ledger (accounting record
book) is also divided into 2 sides:
(dr)
(cr)
“T” account
12
What is an ‘Account’?
 a device to record individual items in
the financial statements
 Anything you want a separate record
of needs its own account (it’s own
page/ledger account)
vehicle
 There are different types
of accounts depending on where
they ‘fit’ in the accounting equation
(A = L + OE)
Dr nature
Cr nature
(left)
(right)
Bank
13
Loan
Some examples of Accounts
 Asset accounts include:
 Cash, Debtors (Accounts Receivable),
Inventory, Motor Vehicles etc.
 Liability accounts include:
 Bank Overdraft, Creditors (Accounts Payable),
Bank Loans etc.
 Owner’s Equity accounts include:
 Capital (for sole traders, partnerships)
 Issued Share Capital; Reserves; Retained
Profits (for companies)
14
Type/nature of account

The type or nature of an accounts depends on the accounting equation
(A = L + OE)

A ledger account is INCREASED by an entry to it’s “usual side” Dr for asset;
Cr for liability

It is DECREASED by an entry on the opposite side
decrease
vehicle
Asset, so debit nature – write an
increase on the Left Side!
increase
decrease
Liability, so credit nature – write an
increase on the Right Side!
Bank
Loan
15
increase
Ledger accounts in “T” Form
Motor vehicle
31st March
Loan
$5,000
Bank Loan
31st March
DEBIT (dr)
A = L + OE
Motor vehicle
CREDIT (cr)
$5,000
16
Normal Account Balances
Account
Assets
Liabilities
Owner’s equity
Normal Balance
Debit
Credit
Credit
Debit
Credit
Credit
Credit
Debit
Debit
17
Explaining Owner’s
Equity
 What changes the amount an owner has invested in the
business – or the amount the business “owes” the
owner?
 Owner invests more capital
 Owner takes out money or value (drawings)
 Any net profit/loss (Income – expenses)
belongs to the owner
Which are increases/decreases to OE?
18
Increases/decreases to OE
 What changes the amount an owner has invested in the
business – or the amount the business “owes” the
owner?
 Owner invests more capital – increase OE
 Owner takes out drawings – decrease OE
 Any net profit/loss (Income/revenue –
expenses) belongs to the owner
 Profit i.e. Income increases OE
 Loss i.e. Expenses decrease OE
19
Equity
A
= L + OE
Equity is Credit nature
Inside OE
Owner’s Equity
Drawings
Expenses/Loss
Capital
Income/Profit
Increases (cr)
Expanding OE in the equation
A + E + D = L + R + OE
DEBIT (dr)
CREDIT (cr)
20
Explaining Owner’s
Equity
A + E + D = L + R + OE
 The Equity section of the accounting
equation can be expanded to analyse
the effects of income (revenue) and
expenses – determines net profit/loss for the
period.
 Reported on the Income Statement
 Net profit/loss is then added to the entity’s
equity on the Balance Sheet.
21
Reports
Make-a-Buck
Income Statement
For the year ended 30 June 2007
Revenue
Service Fees
20,000
Make-a-Buck
Balance Sheet
As at 30 June 2007
ASSETS
Cash
Trade Debtors
Machinery
Expenses
Wages
Electricity
LIABILITIES
Trade Creditors
Bank Loan
17,000
500
17,500
Profit/Loss
2,500
5,000
6,000
11,000
9,000
20,000
6,000
5,000
11,000
EQUITY
Opening Balance of Capital
5,500
Add: additional funds from owner 1,500
7,000
Minus: drawings
(500)
Add: Profit (or deduct loss)
2,500
Closing balance of capital (OE)
9,000
TOTAL LIABILITIES & EQUITY
20,000
ASSETS = LIABILITIES + EQUITY
22
Teresa and her carpet
business – Day 2
2 Apr Teresa signs the lease and writes a cheque for $10 000.
Lease ↑A ↑(Debit)
(left) Dr
Cash ↓A ↓(Credit)
(right) Cr
A
Cash
Both are asset accounts
Assets = Liabilities + Owner’s Equity
Lease
How would the general ledger accounts look?
Cash at bank
= L + OE
Apr 2
$10.000
Lease
23
Teresa and her carpet business
– Day 2 – fill in the Balance
Sheet
Lease ↑A ↑(Debit)
(left) Dr
Cash ↓A ↓(Credit)
(right) Cr
Balance Sheet as at 2 April
Liabilities
Assets
Current
Cash
Non-Current
$
Loan
$
Equity
$
Non-Current
Lease
Capital Contributed
$
$
$
24
Finish example to 5th
April Balance Sheet
Teresa and her carpet business
(Handout)
25
Part B: Process overview
26
General ledger
Traditionally a book containing the collection of
accounts – with its own index the “Chart of
Accounts”
(dr)
“T” accounts
(cr)
Now probably contained in a
computer package e.g. MYOB
27
Journals and Ledger
Ledger ‘pages’ fill quickly!
So similar transactions often listed
chronologically first in a JOURNAL and only
the total posted to (entered in) the relevant
ledger account..
e.g. Sales Journal – credit sales
Each entry will have:
•the date of transaction
•name of accounts affected and
•the corresponding debit and credit
amount.
28
Journals
Ledger
e.g. Sales Journal – credit sales
1 Apr
Joe Smith
5 Apr
Mary Lim
$500
$1,000
11th Apr Tina James
$3,000
TOTAL
$4,500
Accounts Receivable
Apr
Duality starts in
the ledger
account
Sales Revenue
Apr
$4.500
A
=
Accounts
Receivable
L+
$4.500
OE
Revenue
29
Steps in the Basic
Accounting Cycle
Source documents
Journal
Ledger
Trial Balance
Financial
statements
30
Back to the steps in the
basic accounting cycle…
 Source Documents E.g. invoices
 Journal
 chronological transaction recording
 impacts on particular Accounts identified
 Ledger
 the place where all the Accounts are kept together
– duality (double entry) starts here
 Trial Balance
 a list of all the Accounts & balances (dr and cr) –
checks duality
 Financial Statements
 Income Statement, Cash Flow Statement, Balance
Sheet; Statement of Changes in Equity
31
What’s a Worksheet?
 Summarises the duality of business
transactions
 It is a tool to help prepare the reports like a
trial balance
 The worksheet (like the Balance Sheet) is
based on the accounting equation
(A = L + E)
 May take a number of formats (internal
use)
32
Example of a Worksheet
Assets
=
Liabilities
Balance Sheet
+
Equity
Income Statement
Profit/loss
Common Errors in the
Worksheet
 transposition errors

Occurs when one of the digits recorded is transposed for
another digit, e.g. $2309 for one entry and
the dual entry recorded as $2039

Quick test – is the difference of the error divisible by 9?
 single-entry errors


e.g. cash sales of $500 recorded in revenue (as a plus)
column but with no ‘dual’ effect recorded in asset Bank (also
a plus) account.
incorrect entries

when an increase is recorded on one side of the equation
and a decrease on the other side when
it should have been an increase (and vice versa)
34
Income Statement
 Used to calculate net profit (or loss)
 It is the difference between revenue
and expense transactions
 Net profit (or loss) is then transferred
to the Balance Sheet
35
Income statement format
Income
(e.g. sales; fees)
Less Expenses
(e.g. wages; rent; electricity; gas)
= Net Profit (or loss)
36
Example of an Income
Statement
Service
37
Example of an Income
Statement
Income Statement
For the month ended 30th April
Sales
Less: Cost of Goods Sold
GROSS Profit
$40 000
$20 000
$20 000
Less other expenses
Depreciation
exp
Lease Rent payments
Interest Expense
NET Profit
$ 1 584
$18 416
334
1 000
250
Retailer/trader/merchandiser
38
Balance Sheet
 It is a statement of the entity’s assets
and liabilities
 The accounting equation holds true
within the Balance Sheet (i.e. A = L + E)
39
Example of a Balance
Sheet
Note:
A - L = OE
40
Common Balance Sheet format
ASSETS
Current (e.g. cash) and Non-current
(e.g. machinery)
Less LIABILITIES
Current (e.g. creditors) and Non-current
(e.g. loan)
equals NET ASSETS
which also equals
EQUITY
41
Teresa and her carpet business
Continue with the example up to unadjusted
balance sheet at 30th April (page 4)
A + E + D = L + R + OE
Debit
Credit
42
Part C -Balance Sheet
43
The Balance Sheet
 The financial position of an entity at a
particular point in time
 Lists
 Assets
 What the business owns or controls
 Liabilities
 External claims on the entity’s assets
 Owner’s equity
 Internal claims on the entity’s assets
44
Accounting Equation
Assets = Liabilities + Owner’s Equity
45
Assets
 ‘A resource controlled by the entity as
a result of past transactions or other
past events and from which future
economic benefits are expected to
flow to the entity.’
 Future economic benefit
 Controlled by the entity
 Result of past transaction or event
46
Asset
Recognition
 ‘It is probable that any future
economic benefits associated with the
asset will flow to the entity and the
asset has a cost or other value that
can be measured reliably.’
47
Assets
 Examples






cash
receivables (debtors)
prepayments
inventories
property
tangible vs intangible
48
Tangible vs. Intangible Assets
 Tangible assets: assets that you can
touch e.g. furniture
 Intangible assets: do not have
physical substance, e.g. patents,
copyrights held, etc
49
Liabilities
‘A present obligation of the entity arising from
past events, the settlement of which is
expected to result in an outflow from the
entity of resources embodying economic
benefits.’
 A future sacrifice of economic benefits
 A present obligation to another entity
 A result of a past transaction or other past
events
50
Liabilities
Recognition
 ‘It is probable that the outflow of
resources embodying economic
benefits will result and can be
measured reliably.’
51
Liabilities
 Examples




payables (creditors)
tax liabilities
mortgages
loans
52
Equity
 ‘The residual interest in the assets of the
entity after deduction of its liabilities.’
 Equity = Assets – Liabilities
 Categories of Owner’s equity
 Owner’s equity contributed
 Owner’s equity retained
 Reserves
 Equity cannot be defined independently
53
Equity
 Categories
 contributed equity
 Reserves
 Asset Revaluation reserve
 General Reserve
 Foreign currency translation reserve
 retained profits
 outside interests in controlled entities
54
Shareholders’ equity - company
Total
shareholders’
equity
Issued share
capital
Ordinary shares
Preference shares
Reserves
Retained profits
Other types
of reserves
Summary of asset and
liability definition and
recognition criteria
56
Balance Sheet Format
 ‘T’ Format/Horizontal
 Narrative Format/Vertical
 Remember:
 Balance Sheet balances
 i.e. Assets = Liabilities + Equity
 Generally presented in order of liquidity
 Comparative Information (2 years)
 Parent entity and consolidated entity
57
Balance Sheet: alternative formats
 Choice 1: Horizontal or Vertical
(narrative)?
 Choice 2: Which version of the
balance sheet equation will you use?
 Entity approach A = L + OE
 Proprietary approach A-L = OE
58
Entity Approach
(A=L+OE):Horizontal
59
Entity Approach (A=L+OE)
: narrative
60
Which is the most common? Why?
•Narrative
(vertical) –
columns
•Proprietary
– investors
A – L = OE
61
Classification of Items
 Current and Non-current
 Current Assets – expected to be consumed or
converted to cash in next 12 months eg. cash,
inventory, debtors
 Non-Current Assets – normally held on a
continuing basis to generate wealth eg. Land
and buildings
 Current Liabilities – due and payable within 12
months eg. Trade creditors
 Non-current Liabilities – payable beyond 12
months eg. Long term loan
62
Conventions








Business entity convention
Money measurement
Valuation
Going Concern (continuity)
Dual aspect
Conservatism (Prudence)
Stable Monetary Unit
Objectivity/reliability
63
The Business Entity Convention
 the business is treated as separate
from its owners for accounting
purposes
 this means, for example, that the
owner’s personal assets and liabilities
should not be included on the
business’ Balance Sheet
64
The Money Measurement
Convention
 accounting records only those items
that are able to be expressed in
monetary terms
 underpins one of the 2 recognition
criteria – which one?
65
Valuation
The dollar value assigned to assets and
liabilities is called their carrying or book
value
The carrying value can either be:
 Historical cost – i.e. original cost
• Current cost
 Market value
• Present value
So which one do we choose?
66
Valuation

The one that ensures the information is
relevant and reliable
For example



Debtors: net realisable value

i.e. expected collection value

NRV = expected selling price minus any costs involved in the
sale
Inventory: lower of cost or net realisable value
Non-Current Assets: lower of cost or recoverable amount
(selling price or value in use - i.e. amount expected to be
recovered through use and/or sale)

Benefits consumed each period are recorded as an expense of
the business for that period



Depreciation – for tangible non-current assets
Amortisation – for intangible non-current assets
Goodwill - purchased goodwill only
67
The Going Concern/Continuity
Convention
 it is assumed that the business will
continue into the future (rather than
liquidate)
 this has implications in particular for
valuation of assets on the balance
sheet
68
The Dual Aspect
Convention
 results in “double-entry accounting”
 every business transaction has at
least two “aspects” and both are
recorded
 eg. buying inventory on credit: the 2
aspects are the increase in inventory
which is recorded as an asset, and
the increase in a liability (accounts
payable or creditors)
69
The Conservatism/Prudence
Convention
 actual and anticipated losses are
recorded in full, but profits are not
recognised until there is a reasonable
certainty that they will be received
 results in the financial reports taking
a cautious or pessimistic perspective
 counteracts management’s optimism
about trading results?
70
The Stable Monetary
Unit Convention
 money is assumed to retain the same
value over time (inflation is ignored)
 departures from this convention are
common, and accepted, through the
practice of asset revaluation
71
Objectivity/Reliability
 Items included in the financial
statements should be verifiable and
non-subjective
 Preferable to have independent
evidence
72
Balance Sheet Analysis
 liquidity: ability to meet current obligations from
liquid assets. Related to the probability of business
failure.
 mix of assets held: current vs non current. Given
their long term nature, an over-investment in non
current assets can cause cash shortages.
 financial structure: reliance on external vs internal
sources of finance. Important because external
finance involves legal obligations
73
Limitations of the Balance
Sheet
1.
2.
Asset, Liability and Entity values are at a particular point in
time only (these values will change over time)
The entity’s value is not really reflected in balance sheet due
to


3.
Items that generate future benefits or involve future
sacrifices not satisfying definition/recognition criteria
The historical nature (or combinations of cost and fair
values) of the Balance Sheet
Preparing a Balance Sheet involves –
•
•
•
management choices
judgements and
estimations
The Historical Cost
Convention
 assets are recorded at a value based
on their cost of acquisition
 supports the money measurement
convention, prudence
(conservatism) & is reliable
 criticism
 ‘relevance’ vs ‘reliability’ debate
Try the crossword!
76
Trading and its effect
on the Balance Sheet

Profits (increases in wealth) or losses (decreases in
wealth) will alter the owner’s claim against the business
Example: Teresa sold $20 000 worth of inventory for
$40000. Interest expense was $250 for the month
and depreciation on fixtures was $334. The monthly
rent was $1000. Ignore the lease for simplicity.
 Profit/(Loss)
 = $40000-$20000-$250-$334-$1000
 = $18416.

77
 Balance Sheet as at 30 April, 2006
Assets
Liabilities
Current
Cash*
Inventory
Non-Current
Lease
Shop Fixtures
$20 000
Less depreciation $ 334
Current
Accounts Payable
Non-Current
Loan
$78 750
$15 000
$ 10 000
$19 666
$35 000
$50 000
Equity
Capital Contrib. $20 000
+ Retain. Prof. $18 416
$123 416
$38 416
$123 416
 *Cash $40000 + $40000 - $1000 - $250
 #Inventory $35000 - $20000
78