Lecture Notes - 1: Chapter 1: Accounting in Business
Lecture Notes - 1: Chapter 1: Accounting in Business
Accounting Equation
Assets = Liabilities + Equity
The accounting equation applies to all transactions and events, to all companies and forms of organization, and
to all points in time.
Assets are resources a company owns or controls. Examples are cash, supplies, equipment, and land,
where each carries expected benefits. The claims on a company’s assets—what it owes—are separated
into owner and nonowner claims.
Liabilities are what a company owes its nonowners (creditors) in future payments, products, or services.
Equity (also called owner’s equity or capital) refers to the claims of its owner(s). Together, liabilities and equity
are the source of funds to acquire assets. Examples are wage payable
The relation of assets, liabilities, and equity is reflected in the following accounting equation.
The accounting system reflects two basic aspects of a company: what it owns and what it owes. Assets are
resources a company owns or controls. Examples are cash, supplies, equipment, and land, where each
carries expected benefits. The claims on a company’s assets—what it owes—are separated into owner and
non-owner claims. Liabilities are what a company owes its non-owners (creditors) in future payments,
products, or services. Equity (also called owner’s equity or capital) refers to the claims of its owner(s).
Together, liabilities and equity are the source of funds to acquire assets.
Assets are resources a company owns or controls. These resources are expected to yield future benefits.
Examples are Web servers for an online services company, musical instruments for a rock band, and land
for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of
resources. A company that provides a service or product on credit is said to have an account receivable
from that customer.
Liabilities are creditors’ claims on assets. These claims reflect company obligations to provide assets,
products or services to others. The term payable refers to a liability that promises a future outflow of
resources. Examples are wages payable to workers, accounts payable to suppliers, notes payable to banks,
and taxes payable to the government.
Equity is the owner’s claim on assets, and is equal to assets minus liabilities. This is the reason equity is
also called net assets or residual equity.
Transaction Analysis
Let’s look at the identification and recording of business transactions for FastForward, a consulting business
owned by Chas Taylor that focuses on assessing the performance of footwear and accessories. On
December 1, Chas Taylor personally invests K30,000 cash in FastForward and deposits the cash in a bank
account opened under the name of FastForward.
First, we have to identify the assets, liability or equity accounts involved in this transaction. We can see
that the cash account will increase by K30,000 and the owner capital will increase by K30,000.
After this transaction, the cash (an asset) and the owner’s equity each equal K30,000. The source of increase
in equity is the owner’s investment, which is included in the column titled C. Taylor, Capital. (Owner
investments are always included under the title ‘Owner name,’ Capital.)
In transaction number 2, FastForward uses K2,500 of its cash to buy supplies of brand name footwear for
performance testing over the next few months.
This transaction is an exchange of cash, an asset, for another kind of asset, supplies. It merely changes the
form of assets from cash to supplies. The decrease in cash is exactly equal to the increase in supplies. The
supplies of footwear are assets because of the expected future benefits from the test results of their
performance.
In transaction number 3, FastForward spends K26,000 to acquire equipment for testing footwear. This is
an exchange of one asset, cash, for another asset, equipment. The equipment is an asset because of its
expected future benefits from testing footwear.
This purchase changes the makeup of assets but does not change the asset total.
In transaction number 4, FastForward decides more supplies of footwear and accessories are needed. These
additional supplies total K7,100, but as we see from the accounting equation, FastForward has only K1,500
in cash. Taylor arranges to purchase them on credit from CalTech Supply Company.
FastForward acquires supplies in exchange for a promise to pay for them later. This purchase increases
assets by K7,100 in supplies, and liabilities (called accounts payable to CalTech Supply) increase by the
same amount.
This purchase changes the makeup of assets but does not change the asset total.
In transaction number 5, FastForward provides consulting services to a powerwalking club and immediately
collects K4,200 cash.
The accounting equation reflects this increase in cash of K4,200 and in equity of K4,200. This increase in
equity is identified in the far right column under Revenues because the cash received is earned by providing
consulting services. It earns net income only if its revenues are greater than its expenses incurred in earning
them.
In transaction 6 and 7, FastForward pays K1,000 rent to the landlord of the building where its facilities are
located. Paying this amount allows FastForward to occupy the space for the month of December. In
addition, the company pays the biweekly K700 salary of the company’s only employee.
The costs of both rent and salary are expenses, as opposed to assets, because their benefits are used in
December (they have no future benefits after December). These transactions also use up an asset (cash). By
definition, increases in expenses yield decreases in equity. This can be seen in the accounting equation
chart because expenses are subtracted in the equity part of the equation. So, an increase in an expense
account yields the subtraction of a larger number, thus decreasing equity.
In transaction 8, FastForward provides consulting services of K1,600 and rents its test facilities for K300
to a podiatric services center. The center is billed for the K1,900 total. This transaction results in a new
asset, called accounts receivable, from this client. It also yields an increase in equity from the two revenue
components that total K1,900.
In transaction 9, the podiatric center pays K1,900 to FastForward 10 days after it is billed for consulting
services.
This transaction does not change the total amount of assets and does not affect liabilities or equity. It
converts the receivable (an asset) to cash (another asset). It does not create new revenue. Revenue was
recognized when FastForward rendered the services, not when the cash is received.
In transaction 10, FastForward pays CalTech Supply K900 cash as partial payment for its earlier K7,100
purchase of supplies, leaving K6,200 unpaid.
This transaction decreases FastForward’s cash by K900 and decreases its liability to CalTech Supply by
K900. Equity does not change. This event does not create an expense even though cash flows out of
FastForward (instead, the expense is recorded when FastForward derives the benefits from these supplies).
In transaction 11, the owner of FastForward withdraws K200 cash for personal use. FastForward’s cash
decreases. Chas Taylor, Withdrawals increases by K200, which by definition, yields a decrease in equity.
This relationship can be seen in the accounting equation on the slide by the subtraction of the withdrawals
account in the equity section. As the withdrawals account balance increases, total equity decreases.
Withdrawals (decreases in equity) are not reported as expenses because they are not part of the company’s
earnings process. Since withdrawals are not company expenses, they are not used in computing net income.
We have now completed transactions 1 through 11. This is a summary of all eleven of FastForward’s
transactions during the month of December. Why don’t you add all the assets and get a total. Compare the
total assets to the total of liabilities and equity. The books are still in balance after analyzing the eleven
transactions
Financial Statements
This section introduces us to how financial statements are prepared from the analysis of business
transactions. The four financial statements and their purposes are:
1. Income statement — describes a company’s revenues and expenses along with the resulting net
income or loss over a period of time due to earnings activities.
2. Statement of owner’s equity— explains changes in equity from net income (or loss) and from
any owner investments and withdrawals over a period of time.
3. Balance sheet — describes a company’s financial position (types and amounts of assets, liabilities,
and equity) at a point in time.
4. Statement of cash flows — identifies cash inflows (receipts) and cash outflows (payments) over
a period of time.
Income Statement
FastForward’s income statement for December shows revenues and expenses conveniently taken from the
equity columns of the transaction summary. Revenues are reported first on the income statement. They
include consulting revenues of K5,800 and rental revenue of K300. Expenses reflect the costs incurred to
generate the revenues reported. FastForward’s expenses include rent and salaries. Net income (or loss) is
reported at the bottom of the statement. FastForward has net income of K4,400 in December.
The statement of owner’s equity reports information about how equity changes over the reporting period.
This statement shows beginning capital, events that increase it (owner investments and net income), and
events that decrease it (withdrawals and net loss).
FastForward was started this month, so the beginning balance in owner's equity was zero. Chas Taylor
invested K30,000 in the company at the beginning of the month. During December, net income of K4,400
was earned. Notice that the net income flows from the income statement to the statement of owner’s equity.
We must complete the income statement before we can begin work on the statement of owner’s equity. In
addition, K200 withdrawal was made by Chas Taylor, so the ending balance in owner's equity is K34,200.
After we complete this statement, we can prepare the balance sheet.
Balance Sheet
The balance sheet is a summary of assets, liabilities, and equity at the end of the month. Our total assets are
equal to K40,400. This includes cash of K4,800, supplies of K9,600, and equipment of K26,000.
Liabilities include accounts payable of K6,200. Equity is composed of C. Taylor, Capital of K34,200. The
account C.Taylor, Capital flows directly from the statement of owner’s equity. You can see that the books
are in balance because total assets are equal to total liabilities plus equity.
Creditors have claims against our assets of K6,200. The owner has claims to assets of K34,200.
We will cover the statement of cash flows in detail in a later chapter. The statement of cash flows reconciles
to the ending cash balance and is divided into three major sections. The first section reports cash flows from
operating activities. It shows the K6,100 cash received from clients and the K5,100 cash paid for supplies,
rent, and employee salaries. Net cash provided by operating activities for December is K1,000. The second
section reports investing activities, which involve buying and selling assets such as land and equipment that
are held for long-term use . It includes K26,000 for the purchase of equipment. The third section shows
cash flows from financing activities, which include the long-term borrowing and repaying of cash from
lenders and the cash investments from, and withdrawals by, the owner.
Return on Assets
This chapter presents a profitability measure: return on assets. Return on assets is useful in evaluating
management, analyzing and forecasting profits, and planning activities. Dell has its marketing department
compute return on assets for every order. Return on assets (ROA), also called return on investment (ROI
), is defined as net income divided by total average assets. Total average assets is computed by adding the
beginning total assets to the ending total assets and divide the total by 2.
Dell shows a fairly stable pattern of good returns that reflect its productive use of assets. There is a decline
in its 2009 to 2010 ROA reflecting the recessionary period. Dell’s ROA compares favorably with the ROA
for the industry average.
Activity 1.1
You should read Chapter 1 from Text book, (Chapter 1: Page No. 2 to 25) and
You are advised to learn and practise the following Exercises and Problems of this chapter.
Questions Page No.
Demonstration Problem 23
Exercise 1-2 32
Exercise 1-6 33
Exercise 1-8 33
Exercise 1-10 34
Exercise 1-11 34
Exercise 1-19 35