Session-3---The-Accounting-Equation---Kaplan-Financial-UK--ACCA- by sdaferv

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```									3   THE ACCOUNTING EQUATION: EXAMPLE

To illustrate the principles which we covered in Chapter 2, we will follow through, in a
simplified form, the transactions of a small business in its first month of trading.

Percy Pilbeam, having spent 30 years as an insurance clerk, decides to take the plunge and
invest his life savings of £10,000 into a green-grocery business.

Step 1

He opens a business bank account with the £10,000. First of all, what is the dual effect (from
the business’s point of view, remember)?

(a)      £10,000 cash

(b)      £10,000 capital.

Expressed as an equation, this shows:

Net assets =            Capital
£                    £
Cash                          10,000 Capital        10,000

ie.                         Net assets = Capital

Step 2

The business buys fruit from Wooster Wholesalers for £4,000, paying cash for it.

Dual effect:

(a)                 £4,000 of inventories

(b)                 £4,000 less cash

Accounting equation:

Net assets =            Capital
£                    £
Inventories                    4,000     Capital    10,000
Cash                           6,000
________              ________

10,000                10,000
________              ________

Again, Net assets = Capital

Step 3

The business buys £2,000 worth of vegetables from Wooster Wholesalers, but this time, wishing
to conserve its cash, arranges to buy them on credit.

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Dual effect:

(a)        £2,000 more inventories

(b)        A liability or creditor of £2,000

Accounting equation:

Net Assets             Capital
£                     £
Inventories                     6,000 Capital        10,000
Cash                            6,000
________

12,000
Less       Payables            (2,000)
________             ________

10,000                10,000
________             ________

or Net Assets = Capital.

Step 4

The business sells all the fruit for £5,000 cash.

Dual effect:

Is it?

(1)        (a)       £5,000 less inventories
(b)       £5,000 more cash

or is it

(2)        (a)       £4,000 less inventories
(b)       £5,000 more cash

We have a problem.

The first choice has the merit of obeying the principle set out in paragraph 2.3 above  that the
two effects of a transaction are always equal. But unfortunately, if we say that Percy has
£5,000 less inventories, this leaves him with only £1,000: and the vegetables, which he still has,
cost £2,000.

What’s missing?

He has £4,000 less inventories, £5,000 more cash but the business has made £1,000 profit.

Percy has, of course, made a profit of £1,000 by buying the fruit for £4,000 and selling it for
£5,000. In the accounting equation, try to work out where to put this profit by thinking about
capital in paragraph 2.4.

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£                       £
Inventories                   2,000       Capital    10,000
Cash                         11,000       Profit      1,000
________

13,000
Less     Payables            (2,000)
________                ________

11,000                  11,000
________                ________

By showing the profit as an addition to capital (as we had to, to make the equation balance), we
have shown what Percy has achieved. Having started off with £10,000 he has added £1,000 to
it. He now has £11,000 invested in the business: from the business’s point of view this is called
capital.

So the summary of the equation is now:

Net Assets = capital.

One further point before moving on. If Percy’s customer didn’t pay him for the fruit
immediately, we would still record the transaction; but instead of recording £5,000 more cash,
we would show it as a receivable. This is still an asset, since the receivable will (we hope)
eventually pay up and the asset ‘receivable’ will be converted into cash. Total assets remain the
same.

Would the payment of cash by a receivable make any difference to profit?

No, because we have already recognised the profit.

Step 5

A business’s transactions cannot all be simply purchases and sales. It has to pay incidental
expenses such as rent, rates, electricity, telephone and postage.

Suppose Percy pays an electricity bill, in cash, amounting to £200. What is the dual effect?

(a)      £200 less cash

(b)      An expense of £200 which will reduce profit.

Accounting equation:
£                                  £
Inventories                   2,000       Capital               10,000
Cash                         10,800       Profit                   800
________

12,800       (1,000  200)
Less     Payables            (2,000)
________                           ________

10,800                             10,800
________                           ________

What would the dual effect have been if he had incurred an electricity bill for £200 but didn’t
pay it straight away?
(a)      A liability or payable of £200
(b)      £200 less profit (as above).

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Step 6

Percy buys a Ford van for £4,000 cash. This is an asset which he will keep longer than his
inventories, but it is still an asset, and should not cause you any problem at the moment.

Dual effect:

(a)      A van (an asset) of £4,000

(b)      £4,000 less cash.

Accounting equation:

£                     £
Van                             4,000     Capital    10,000
Inventories                     2,000     Profit        800
Cash                            6,800
________                ________

12,800                 10,800
Less     Payables             (2,000)
________                ________

10,800                 10,800
________                ________

If you thought that this transaction affected profit, like the electricity bill, remember that an
asset is something owned by a business, whereas the charge for electricity is an expense. It
should normally be clear which items are assets and which are expenses: if in doubt think
whether the item will still be in existence as part of a business’s property at the end of a period
(month, year etc). If it will, it’s an asset.

Step 7

The final step in this chapter reminds us that Percy must gain some personal benefit from the
business. He no longer earns a salary, so in order to feed himself and his family he draws £500

What is the dual effect of this (from the business’s point of view, remember)?

Clue: it’s the opposite of putting capital in.

(a)      £500 less cash

(b)      £500 drawings which reduces capital.

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Percy’s final accounting equation at the end of his first month of trading should now look like
this:

£                          £
Van                     4,000 Capital             10,000
Inventories             2,000 Profit                 800
Cash                    6,300
________                    ________

12,300               10,800
Less     Payables (2,000) Less Drawings (500)
________                    ________

10,300                     10,300
________                    ________

Assets  Liabilities              = Capital + Profit  Drawings
or Net Assets                     = Capital at end of period

Final note

You may have been wondering why we haven’t mentioned the words debit and credit, which
are often supposed to be what bookkeeping is all about. In fact, debit and credit are merely
conventions used in writing up books of accounts so as to give effect to the dual nature of each
transaction.

Debits and credits will come in later on; at the moment we hope that you will find it more
helpful to understand the basic principles of what accounts are and why they are produced,
before getting down to the mechanics of producing them.

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