Module 2: The Accounting Equation

• Assets, Liabilities and Equity – relate to a reporting entity’s financial position (balance sheet).
• Income and Expenses – relate to a reporting entity’sfinancial performance (income statement).
• Asset => a present economic resource controlled by theentity as a result of past events. An economic resource is a right that has the potential to produce economic benefits.
• Three Aspects of an Asset:

  1. Right
  2. Could produce an economic benefit
  3. Entity controls an economic resource
• The Rights of handling an asset:

  • Rights that correspond to an obligation of another party.
  • Rights that do not correspond to an obligation of another party
• Rights that correspond to an obligation of another party:

  1. Rights to receive cash
  2. Rights to receive goods and services
  3. Rights to exchange economic resources
  4. Rights to benefit from an obligation of another party to transfer an economic resource
• Rights that do not correspond to an obligation of another party:

  1. Rights over physical objects, such as property, plant and equipment or inventories.
  2. Rights to use intellectual property.
• Could produce economic benefits:

  1. Receive contractual cash flows or another economic resources
  2. Exchange economic resources with another party on favorable terms
  3. Produce cash inflows or avoid cash outflows
  4. Receive cash or other economic resources by selling the economic resource
  5. Extinguishing liabilities by transferring economic resource.
• Entity controls an economic resource

  • It has the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it.
  • Includes the present ability to prevent other parties from directing the use of the economic resource and from obtaining the economic benefits that may flow from it.
• Liabilities => a present obligation of the entity to transfer an economic resource as a result of past events.
• For a liability to exist, three criteria must ALL be satisfied:

  1. The entity has an obligation
  2. The obligation is to transfer an economic resource
  3. The obligation is a present obligation that exists as a result of past events
• Obligation

  • is a duty or responsibility that an entity has no practical ability to avoid.
  • is always owed to another party/parties
• Other Party

  • Could be a person or another entity.
  • Its not necessary to know the identity of the party to whom the obligation is owed.
• Obligation to transfer an economic resource to:

  1. Pay cash
  2. Deliver goods or provide services
  3. Exchange economic resources with another party on unfavorable terms
  4. Transfer an economic resource if a specified uncertain future event occurs
  5. Issue financial instrument if that financial instrument will oblige the entity to transfer economic resource.
• Present obligation exists as a result of past events only if:

  • The entity has already obtained economic benefits or taken an action
  • The entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. (As a consequence)
• Equity

  • Residual interest in the assets of the enterprise after deducting all its liabilities.
  • They are claims against the entity that do not meet the definition of liability.
• Sole Proprietorship – Owner’s equity

  Partnership – Owner’s equity

  Corporation – Stockholders’ equity
• Income => increases in assets, or decrease in liabilities, that result in increase in equity, other than those relating to contributions to holders of equity claims.
• Expenses => decreases in assets, or increase in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.
• Account

  • Basic summary device of accounting
  • Detailed record of the increases, decreases and balance of each element that appears in the entity’s financial statements
• T Account => the simplest form of the account
• The Accounting Equation

  • Most basic tool of accounting
  • This equation presents the resources controlled by the enterprise, the present obligations of the enterprise and the residual interest in the net asset.
  • It states that assets must always equal to liabilities and owner’s equity.
  • The equation also explains why liabilities and owner’s equity follow the same rules of debit and credit.
  • The logic of debiting and crediting is related to the accounting equation.
• Basic Accounting Model:

  Assets = Liabilities + Owner’s Equity
• The Accounting Equation may become:

  • Assets - Owner's Equity = Liabilities; or
  • Assets - Liabilities = Owner's Equity
• Debit and Credit is also known as the double entry system..
• Debit and Credits – The Double Entry System

  • Accounting is based on a double-entry system which means that the dual effects of a business transaction is recorded.
  • A debit side entry must have a corresponding credit side entry.
  • Total debits for a transactions must always equal to total credits
  • An account is debited when an amount is entered on the left side of the account and credited when an amount is entered on the right side.
• Normal Balance of Accounts:

  Debit => Assets, Owner's Drawings, and Expenses

  Credit => Liabilities, Owner's Equity, and Income
• Accounting Event => an economic occurrence that causes changes in an enterprise’s assets, liabilities, and/or equity.
• Internal – use of equipment for production of goods andservices.
• External – purchase of raw materials from a supplier.
• Two Kinds of Accounting Events:

  • Internal
  • External
• Transaction => a particular kind of event that involves the transfer of something of value between two entities.
• Four Types of Transactions:

  1. Source of Assets
  2. Exchange of Assets
  3. Use of Assets
  4. Exchange of Claims
• Source of Assets (SA) – an asset account increases and acorresponding claims (liabilities or owner’s equity) account increases.
• Exchange of Assets (EA) – one asset account increasesand another asset account decreases.
• Use of Assets (UA) – an asset account decreases and acorresponding claims (liabilities or equity) accountdecreases.
• Exchange of Claims (EC) – one claims (liabilities orowner’s equity) account increases and another claims(liability or owner’s equity) account decreases.
• Assets are current when:

  • Expects to realize the asset, or intends to sell or consume it , in its normal operation.
  • It holds the asset primarily or the purpose of trading
  • Expects to realize the asset with 12 months
  • Asset is a cash or cash equivalent
• Non-Current Assets => assets that are not current
• Operating Cycle

  • It is the time between the acquisition of assets for processing and their realization in cash or cash equivalents.
  • If the operating cycle is not clear assumed to be 12months.