ICAEW CFAB

ACCOUNTING

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Topic List
Assets, liabilities and the business entity concept
The accounting equation

Credit transactions
The statement of financial position
Preparing the statement of financial position
The statement of profit or loss

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Chapter 2
THE ACCOUNTING
EQUATION

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Outcome
Upon completion of this chapter, you will be able to:

• Record and account for transactions and events resulting in income,

expenses, liabilities, and capital (in accordance with regulations and
accounting standards)

• Identify the main components of a set of financial statements and

specify their purpose and interrelationship
Assets, liabilities and the business entity concept
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. Assets are classified
into two types: NON-CURRENT ASSETS and CURRENT ASSETS
Liability
is 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.

Equity
is the residual interest in the assets of the entity after deducting all its
liabilities. Equity is also the amount invested in a business by the
owners.

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Assets, liabilities and the business entity concept

A company is recognized by law as a separate legal entity

from its owners.

A company may, in its own name, acquire assets, incur debts,

and enter into contracts
Assets, liabilities and the business entity concept
The future economic benefit: embodied in an asset is the potential to contribute,
directly or indirectly, to the flow of cash and cash equivalents to the entity.

The future economic benefits embodied in an asset may flow to the entity in a
number of ways. For example, an asset may be:

used singly or in combination with other assets in the production of goods

or services to be sold by the entity;
exchanged for other assets;
used to settle a liability; or
distributed to the owners of the entity.

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Assets, liabilities and the business entity concept
The settlement of present obligation: usually involves the entity giving up resources
embodying economic benefits in order to satisfy the claim of the other party.

Settlement of a present obligation may occur in a number of ways, for example, by:

payment of cash;

transfer of other assets;

provision of services;
replacement of that obligation with another obligation; or
conversion of the obligation to equity.

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Assets, liabilities and the business entity concept

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 Assets, liabilities and the business entity concept
Example of Assets: Land & buildings
Motor Vehicles
Plant & Machinery
Fixtures & fitting
Cash
Inventory
Receivables (debtors)

Example of Liabilities
Bank loan or overdraft
Payables (creditors)
Taxation

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 Assets, liabilities and the business entity concept
Income
is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.

Revenue
arises in the course of the ordinary activities of an entity and is referred to by a variety of different
names including sales, fees, interest, dividends, royalties and rent.

Other Gain
represent other items that meet the definition of income and may, or may
not, arise in the course of the ordinary activities of an entity. Gains
represent increases in economic benefits and as such are no different in
nature from revenue.

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 Assets, liabilities and the business entity concept
Expenses
are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants
The definition of expenses encompasses losses as well as those expenses that arise in the course
of the ordinary activities of the entity
Other Losses
represent other items that meet the definition of expenses and may, or may not, arise in the
course of the ordinary activities of the entity. Losses represent decreases in economic benefits
and as such they are no different in nature from other expenses. Losses are often reported net of
related income.
Business entity concept
A business is a separate entity from its owner.

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The Accounting Equation
EQUITY LIABILITIES TOTAL ASSETS

Total Assets – Total Liabilities = Capital

Assets = Capital + Liabilities – Drawings + Profit

Equity/Capital = Capital Introduced + Retained Profits

Equity/Capital = Capital Introduced + (Earned Profit – Drawing)

Profit/Loss = Revenue - Expenditure

Drawings The owner of a sole trader ship does not get paid a wage;
they “draw out” or appropriate some of their capital as drawings.
Drawings: Money and goods taken out of a business by its owner

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 The Accounting Equation
Double Entry
Double entry bookkeeping is based on the idea that each transaction has an equal but
opposite effect. Every accounting event must be entered in ledger account both as debit and
as credit. Every transaction has two effects ➔ dual effect

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The Accounting Equation You own car worth
$10,000 $10,000
Purchase Your cash less
$10,000

You own car worth

$10,000 $10,000
Purchase You owe bank
$10,000

You have cash less

$500 $500

Repair You incurred expense

$500
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Example:
Assets = capital + liabilities: Assets = Capital +0
Example: Charlie has put £2,500 into the business of a flower stall. The business is a
separate entity in accounting terms and so it owes the money to Charlie as capital.
Capital is an investment with the intention of earning a return, accountants will treat
the capital as money owned to the owner by the business

Cash at bank £2,500

Cash invested £2,500

We can express Charlie’s initial accounting equation as follows

Assets = Capital + Liabilities

£2,500 (cash at bank) = £2,500 + 0

Example
Assets = capital + liabilities: Assets = Capital +0
Charlie purchases a market stall for £1800. They also purchase flowers at a cost of £650
Charlie keeps £30 in the bank and holds £20 in small change for trading

Assets = Capital + Liabilities

Stall 1800 2,500 0

Flowers 650

Cash at bank 30

Cash in hand 20

Total 2500
The Accounting Equation
Double Entry
Double entry bookkeeping: Method recording financial transaction
Account is maintained for every supplier, customer, asset, income, expenses
Every transaction recorded twice so every debit is balanced by a credit

Rule of Double Entry

Assets/Expenses Liabilities/Capital/Income

Debit Credit Debit Credit

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The Accounting Equation
Double Entry - Remember
EXPENSES have same direction with ASSET
INCOMES/ REVENUE have same direction with LIABILITY/ CAPITAL

Debit Credit
Left hand side Right hand side
✓ To own/have ✓ To owe

✓ An asset ✓ An asset

✓ Capital/Liability ✓ Capital/Liability

✓ Income ✓ Income

✓ Expense ✓ Expense

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The Accounting Equation
Stockholder’s Equity
Increase: Investments by stockholders, Revenue
Decrease: Dividends to stockholders, Expenses

Investments by stockholders
Represent the total amount paid in by stockholders for the shares they purchase

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The Accounting Equation
Revenues
Result from business activities entered into for the purpose of earning income.
Common sources of revenue are: sales, fees, services, commissions, interest, dividends, royalties,
and rent.

Dividends
Are the distribution of cash or other assets to stockholders.
Dividends reduce retained earnings. However, dividends are not an expense.

Expenses
Are the cost of assets consumed or services used in the process of earning
revenue.
Common expenses are: salaries expense, rent expense, utilities expense,
tax expense, etc.

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 Credit Transaction
TRADE PAYABLES
Creditor

Person to whom a business owes money.

A Trade Creditor

Person to whom a business owes money for trading debts

Trade Payables

The amounts due to credit suppliers.

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 Credit Transaction
TRADE RECEIVABLES
Debtor

Person who owes money to the business

Trade Receivables

The amounts owed by credit customers

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Worked Example
Worked Example: Assets = Capital + Liability
Look at the consequences of the following transactions in the week to 1 7 July 20X6. (See Worked example: Assets = capital
for the situation as at the end of 10 July.)
(a) Liza Doolittle realises that she ¡s going to need more money in the business and so she makes the following
arrangements.
1) She invests a further £250 of her own capital.
2) She persuades her Uncle Henry to lend her £500. Uncle Henry tells her that she can repay the loan whenever
she likes, but in the meantime, she must pay him interest of £5 each week at the end of the market day. They
agree that it will probably be quite a long time before the loan is eventually repaid.
(b) She decides to buy a van to pick up flowers from her supplier and bring them to her market stall. She finds a car
dealer, Laurie Loader, who agrees to sell her a van on credit for £700. Liza agrees to pay for the van after 30 days’ trial
use.
(c) During the week, Liza’s Uncle George telephones her to ask whether she would sell him some garden furniture. Liza
tells him that she will look for a supplier. She buys what Uncle George has asked for, paying £300 in cash. Uncle
George accepts delivery of the goods and agrees to pay£350, but he asks if she can wait until the end of the month
for payment. Liza agrees.
(d) Liza buys flowers costing £800. Of these purchases £750 are paid in cash, with the remaining £50 on seven days’
credit. Liza decides to use Ethel’s services again, at an agreed wage of £40 for the day.
(e) On 17 July, Liza sells all her goods, for £1,250 (cash). She decides to withdraw £240 for her week’s work. She
also pays Ethel £40 ¡n cash. She decides to make the interest payment to her Uncle Henry the next time she sees him.
(f) There are no van expenses for the week.

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Worked Example
Answer:
Deal with transactions one at a time in chronological order. (In practice, it is possible to do one set of calculations
which combines all transactions.)
(a) The addition of Lizas extra capital and Uncle Henrys loan
An investment analyst might call Uncle Henry’s loan a capital investment, on the grounds that it will probably be
for the long term. Uncle Henry is not the owner of the business, however, even though he has made an
investment in it. He would only become an owner if Liza offered him a partnership in the business, and she has not
done so. To the business, Uncle Henry is a long term creditor, and it is appropriate to define his investment as a
liability and not business capital. The accounting equation after ((250 + 500) = £750 cash is put into the business
will be:

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Worked Example

Answer:

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Worked Example

Answer:

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The Statement of Financial Position
Shows its financial position at a given moment in time

Reports the assets, liabilities, and stockholders’ equity at a specific date.

Lists assets at the top, followed by liabilities and capital.
Total assets must equal total liabilities and capital
It is a snapshot of the company’s financial condition at a specific moment in time
(usually the month-end or year-end).

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 The Statement of Financial Position
Assets
Current Asset: Are expected to be converted into cash within 1 year
Cash
Inventory
Trade and other receivables
Short-term investments
Prepayments (Prepaid expenses)

Non-current Asset: Are acquired for long-term use within the business
Property, plant and Equipment (Tangible Asset – PPE)
Intangible Non-current assets
Long-term investments

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• Current Asset:
o Cash or a cash equivalent
o Inventory for resale (intend to sell them within one year)
o Any trade and other receivables, will be paid within the usual cash operating cycle of
less than one year
o Short-term investments: These are stocks and shares of other businesses with the aim
to make a profit in the short term and must be readily realizable (ie, easy to sell) in the
near future.
o Prepayment: These are amounts of money paid by the business in one reporting period
o Trade and other receivables (as we have learnt before)
The Statement of Financial Position
NCA and Depreciation

Non-current assets are held and used by a business for a number of years,
but they wear out or lose their usefulness in the course of time.
Every tangible non-current asset has a limited life. The only exception is
freehold land.

Example: A machine costing £1,000 and expected to wear out after 10

years. If a financial statement were drawn up 4 years after the asset was
purchased.
Machine at original cost 1,000

The depreciation amount each year (100)

Less accumulated depreciation (400)

Carrying amount 600

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 The Statement of Financial Position
Liabilities Net Asset = Asset - Liability

Current Liabilities: Are debts which are payable within one year
Loans: repayable within one year, including element of a long term
loan that is repayable within one year
Bank overdraft (repayable on demand)
Trade payable
Taxation payables
Accruals, other payables,…

Non-current Liabilities: Are debts which are payable after one year
Loans: not repayable for more than one year, ie. bank loan, loan
from individual or business
Loan stock or debentures (limited company)

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The Statement of Financial Position
Capital (Sole trader)
The sole trader's capital is usually analysed into its component parts.
'Brought forward' means that the amount is brought forward from the previous
period. Similarly, 'carried forward' means carried forward to the next period.
£ £
Capital at the beginning of the reporting period
(ie capital brought forward) X
Add additional capital introduced during the period X
X
Add profit earned during the period (or less losses incurred in X
the period)
Less drawings (X)
Retained profit for the period X
Capital as at the end of the reporting period (ie capital carried X
forward)
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Preparing the statement of financial statement

Step 1
Gather the needed information

Step 2
Prepare the heading

Step 3
Report all company assets

Step 4
Report all liabilities

Step 5
Report the ending balance of capital after total liabilities

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Worked Example

Worked Example: Statement of Financial Position

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Worked Example

Answer:

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Statement of Profit or Loss
Statement of Profit or Loss

Is a statement in which two key elements of financial statements – income and

expenses – are matched to arrive at profit or loss
Many businesses distinguish between:
➢ Gross Profit earned on trading (revenue – cost of sales)
➢ Profit for the year (Net Profit/Net Income) after other income and expenses Reports
the profitability of the company’s operations over a specific period of time. Lists
revenues first, followed by expenses.
Shows net income (or net loss).

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Statement of Profit or Loss
Gross Profit

Cost of sales
In a retail business, COGS is their purchase cost from suppliers
In a manufacturing business, the production COGS is the cost of raw materials in the Finished
goods, plus labour costs required to make the goods, plus an amount of production
‘overheads’ costs.

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Statement of Profit or Loss
Element of P/L

Revenue - Expense
Cost of Sales: the purchase or production cost of the goods sold
Gross Profit = Revenue – Cost of Sales
Profit for the year = Gross profit – Expenses + Non-trading income
Gross profit margin = "Gross Profit " /"Revenue" x 100
SOPL matches income earned to the expenses of earning that income
Prepayments – excluded from expenses in PL, included in receivables in the SOFP
Accrued expense – added to expenses in the SOPL and shown as payables in SOFP

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Statement of Profit or Loss
Net Profit

Gross Profit XXXX

Plus any other income from source other than the sale of goods X

Minus other business expenses, not included in the cost of good sold (XX)
XXX

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Statement of Profit or Loss
Net Profit
Income from other source
Profit on disposals of non-current assets
Dividends or interest received from investments
Rental income from property owned but not otherwise used by the business
Amounts due in respect of insurance claims
Cash Discounts received

Business expense, other than COGS

Distribution costs/selling expense: salaries, wages, commission of employees; marketing costs, depreciation
Administrative costs/expense: management & office staff salaries, rent, insurance, telephone and postage, …
Finance costs/financial expense: interest on loans, bank overdraft interest

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Statement of Profit or Loss
Relationship: SOFP - SOPL

Net profit is the profit for the period. A net loss would be transferred as a
deduction from capital in the statement of financial position.
Drawings are appropriations of profit and not expenses.

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Worked Example
Worked Example: Statement of Profit or Loss
On 1 June 20X5, Jock Heiss commenced trading as an ice cream salesman, using a van.
(a) He borrowed £2,000 from his bank, and the interest cost of the loan was £25 per month.
(b) He rented the van for £1,000 for three months. Running expenses for the van averaged £300 per month.
(c) He hired an assistant for £1 00 per month.
(d) His main business was to sell ice cream to customers in the street, but he also did special catering for business customers,
supplying ice creams for office parties. Sales to these customers were usually on credit.
(e) For the three months to 31 August 20X5, his total sales were as follows.
• Cash sales £8,900
• Credit sales £1,100
(f) He purchased his ice cream from a local manufacturer, Floors Co. The purchase cost in the three months to 31 August 20X5
was £6,200, and at 31 August he had sold every item. He still owed £700 to Floors Co for unpaid purchases on credit.
(g) One of his credit sale customers has gone bankrupt (insolvent), owing jock £250. Jock has decided to write off the debt in full,
with no prospect of getting any of the money owed.
(h) He used his own home for his office work. Telephone and postage expenses for the three months to 31 August were £150,
which he paid in cash.
(i) During the period he paid himself £300 per month. A statement of profit or loss can be presented in various formats, but here
we will use a vertical format similar to the one used in IAS 1. (It is not exactly the same.)

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Worked Example

Answer:

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Example: Fraudulent financial reporting
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