Unit 1

The need for accounting and the accounting

equation
After studying this chapter you should be able to:

 Explain the nature and role of accounting

 Identify the main users of accounting information and their information
needs
 Explain the various assumptions used in preparing financial statements
 Record business transactions using the accounting equation

1.0 Introduction
What is accounting?

Accounting is concerned with collecting, analyzing and communicating

financial information to those people who need the information for decision
making, planning and control purposes. For instance the manager of a business
may need accounting information to decide whether to:

 Develop new products or services;

 Increase or decrease the price or quantity of existing products or services;
 Borrow money to help finance the business.

The information provided should help in identifying and assessing the financial
consequence of these decisions (Atrill and Mc Laney). Apart from managers
other people/ organizations are also interested in accounting information.

1.1 Users of accounting information

Lenders- Banks and other financial institutions need to assess the ability of the
business to pay what is due to them.

Employees- they are interested in the security of their employment. They want
to assess whether the business will survive and continue to provide employment
and pension benefits.

The government and its agencies- for collecting appropriate taxes and for
regulating the activities of the business in the interest of the whole community.
Investors- Investors invest their money to earn a financial return on their
investment. They need information which will help them to make financial
decision. In case of shareholders in a company their decision will involve
whether to buy, hold or sell shares in the company.

The public- The public in general might have an interest in the financial
statements of a company. A company might employ people in the vicinity of its
location or could support local suppliers.

1.2 Underlying assumptions when preparing financial statements

Separate entity

When accounting for transactions, it is assumed that the entity for which the
accounting records are maintained is separate from its owner(s). A clear
dividing line is assumed to exist between the business and its owner. Without
such boundary it would be difficult to identify the resources and activities of the
business from those of its owner. The capital contributed by the owner is treated
as a liability from the entity’s perspective as the business is assumed to have
borrowed this amount from its owner. Applying the boundary rule if the owner
purchases a sofa set for his house from his private funds, no records for this
transaction should be kept in the books of the business.

Going concern

The financial statements are prepared assuming that the business is a going
concern i.e. the entity will be in operation in the foreseeable future and there is
no intention to close down the business or curtail its activities significantly.
Thus, it is not in the interest of the business to know the realizable (saleable)
value of the business. As such, non-current assets are shown at depreciated
historical cost even if the realizable value is higher. If a business is not a going
concern, the assets should be shown in the statement of financial position at the
amount they may be expected to realize when sold.

Money measurement

An entity’s accounting records are kept using a common unit of measurement

such as$. This makes comparison between entities or with the same entity easier
over time. Only transactions which are capable of being measured in monetary
terms are recorded in the books on the entity. For this reason the financial
statements of an entity shows a limited picture of the affairs of the business. For
instance, if the health of a sole trader is failing, can this be shown in the
financial statements? Since the effect cannot be quantified reliably it cannot be
shown. This is one of the reasons for the increase in narrative content in the
annual report of companies.

Realisation concept

The realization concept requires that income should not be recorded in the
accounts unless it has been realized. It is inappropriate to include the profit on a
transaction in the income statement if the transaction has not happened yet. As a
general rule a sale is deemed to happen when the goods which are subject to
sale have been replaced by cash or a debtor for the sale.

Accruals including matching

Revenue, other income and expenses should be recognized, recorded and

reported in the financial statements based in the period in which they occur and
not when cash is received or paid. A credit sale which occurs just before the
yearend should be recorded in the period in which the sale has occurred not
when cash will be received from debtors. The revenue (sales) figure in the
income statement includes both cash and credit sales. Expenses shown in the
income statement are expenses which relates to the accounting period and not
necessarily expenses paid. Expenses which have been incurred but not paid
must be accrued and shown in the statement of financial position under current
liabilities. Similarly, expenses which have been paid but relates to a future
accounting period should be treated as ‘prepaid expenses’ and shown under
current assets in the statement of financial position. Financial statements which
are prepared on an accrual basis inform users not only of past transactions
involving payments and receipt of cash but also of obligations to pay cash in the
future and resources which represent cash in the future (Framework for the
presentation of financial statements).

Historical cost

It is common accounting practice to record assets and expenses at cost price.

Historical cost accounting has the virtue of being objective. The cost of assets,
goods and services purchased is ascertainable from invoices, contracts or
costing records if an asset has been built by an entity’s own work force.
However, it has some shortcomings; it fails to take into account the changing
value of money and cannot record assets and services for which no payment has
been effected.

Materiality

In the accounting context materiality means assessing the significance of the

information to stakeholders. An item is said to be material if its inclusion or non
inclusion will affect the way users view the financial statements. The concept of
materiality permits the normal accounting treatment of an item to be
disregarded if the amount involved is not significant in the context of the
business as a whole. For example, a multinational company purchasing a laptop
costing $800 may teat the purchase as an expense while a small company can
treat the same purchase as an asset, on account of their size.

Prudence

Prudence is the exercise of caution under conditions of uncertainty. The

objective is to ensure that income and assets are not overrated and liabilities are
not underrated. The uncertainties could be of a recurring nature such as
providing for bad debts. If the allowance set is too low this will result in profit
and receivables being overstated. However, an overstatement of expenses or
liabilities is not permitted on the grounds of prudence. For example if a
company knows based on past experience that 2% of receivables might turn into
bad debt, it would be inappropriate to make an allowance of 10% of trade
receivables.

Substance over form

Information contained in financial reports should represent the substance or

economic reality of a transaction even if it differs from the legal form. For
example A sells a stock of whisky to B for $25,000 subject to an agreement that
A can buy back the stock of whisky at anytime subject to a payment of a
specified interest rate for the period until the sock is bought back. The
commercial substance of this transaction is not a sale but a financing
arrangement with the stock of whisky as security. The transaction should be
recorded as a financing arrangement and not as a sale.
1.3 Types of business entity
The term entity is used to describe any form of business organization. There are
three main types of business all aiming to make profit; sole trader, partnership
and limited company.

Sole trader

An individual who sets up in business on his own is a sole trader. A sole trader
is owned and managed by one person. The sole trader suffers from unlimited
liability. The owner is personally liable for the debts of the business. If the
business does not have enough money to pay its debts, the owner can be made
personally liable to make payment out of his ‘non-business’ assets. The profit of
a sole trader is treated as income for taxation purposes.

Partnership

A partnership is an association of two or more people who pool their resources

to set up a business. A partnership just like a sole trader can have employees but
they have no share in the ownership. A partnership deed is drawn which sets out
the terms of the partnership. The partners are personally responsible for the
debts of the business. Alike sole traders the personal assets of partners are at
stake. The share of profit of each partner is treated as personal income for the
purpose of calculating the tax liability.

Limited Company

Ownership of a company is represented by ownership of shares. Shareholders

(owners) appoint directors to manage their business. Unlike a sole traders or a
partnership, a company has a separate legal status. This means that in the eyes
of the law a company is regarded as a person. As such the company can own
assets and can sue and be sued in its own name. A company pays tax separately
from its owners. Shareholders in a limited company benefit from limited
liability meaning that their liability is limited to the amount that they have
invested in the business. If the company’s shares are ‘fully paid’ shareholders
have no further liability as regards the unpaid debts and further obligations of
their company. This is the main reason why limited company is the most
common form of business organization.

1.4 The Accounting Equation

To start a business we require funds. These funds can basically come from two
sources; past savings of the owner or borrowing (loan). You would recall that
the business entity concept regards the business as being separate from its
owner. Let’s assume that Devi commences business with $10,000 in the bank.
The business of Devi is an entity created separate from herself that has acquired
the $10,000 (bank). At the same time the business has incurred a liability or
debt of $10,000 to the owner. The accounting equation depicts the equality
which must exist between the resources owned/controlled by the business and
the claims against these resources. In its simplest form the accounting equation
is:

Assets = Capital

Resources (uses of funds) = Sources of Funds (where they come from)

The accounting equation for Devi’s business can be stated as follows:

Assets = Capital
Bank = Capital
$10,000 = $10,000

Let us now assume that the funds required are not sufficient and Devi borrows
$5,000 from the bank (loan). The accounting equation can be states as follows:

Assets = Capital + Liabilities

Bank = Capital + Loan
$10,000 + = $10,000 + $5,000
$5,000

The loan increases the bank account balance by $5,000. The bank account
balance stands at $15,000. Where does the $15,000 come from? Part of it was
introduced by the owner ($10,000) and the remainder by borrowing from the
bank ($5,000).
1.5 Elements in the accounting equation

Assets are rights or access to future economic benefits controlled by an entity as

a result of past transaction or events. At this point we can take assets to be what
the business owns. They consist of land, buildings, machinery, motor vehicles,
stock of goods, debts owed by customers called receivables/debtors, cash at
bank and cash in hand.

Liabilities are the obligation of an entity to transfer economic benefits as a

result of past events. Liabilities are amounts owed by the business to external
parties. They include suppliers of credit purchases called payables, loans,
unpaid expenses and bank overdraft.

Owner’s Equity or Capital is the residual amount found by deducting all of

the entity's liabilities from the entity's assets. This represents the owner’s claim
on the business. The owner’s equity can be derived from the accounting
equation by rearranging the elements in the accounting equation.

Capital = Assets - Liabilities

Owner’s equity can increase when the owner injects additional funds in the
business or when the business makes profit. Alternatively, owner’s equity will
decrease when the owner withdraws assets for personal use or when the
business incurs a loss.

Taking into account the items which can impact on capital, we can rewrite the
accounting equation as follows:

Assets = Capital + Profit - Drawings + Liabilities

We can rearrange the accounting equation to avoid the negative sign as follows:

Assets + Drawings = Capital + Profit + Liabilities

Worked example

20X8

Oct 1 Yan commenced business by depositing $25,000 in a bank account.

Oct 4 A delivery van was purchased by cheque for $12,000.

Oct 10 Goods for resale costing $3,000 were purchased on credit from Ali.

Oct 20 Yan withdrew $500 from the business bank account for his personal

use.

Oct 22 Paid Ali $800 on account by cheque.

Oct 1 Yan commenced business by depositing $25,000 in a bank account.

The business has an asset, bank ($25,000) and simultaneously an owner’s equity
of $25,000 is created. The accounting equation is as follows:

Assets = Capital
Bank = Capital
+25,000 = +25,000

Oct 4 A delivery van was purchased by cheque for $12,000.

This transaction results in an increase in assets (vehicle) and a corresponding

decrease in another asset (Bank).

Assets = Capital
Bank Vehicle = Capital
+25,00 = +25,00
0 0
-12,000 +12,000 = 0
13,000 12,000 = 25,000

Oct 10 Goods for resale costing $3,000 were purchased on credit from Ali.

These are goods for resale which increases inventory with a corresponding
increase in payables (creditors).

Assets = Capital + Liabilities

Bank Vehicle Inventory = Capital Payable
13,000 12,000 = 25,000
+3,000 = +3,000
13,000 12,000 3,000 = 25,000 + 3,000

Oct 20 Yan withdrew $500 from the business bank account for his personal

use.

The withdrawal of cash from the business for personal use increases drawings
(decreases owner’s equity) and results in a decrease in the bank account
balance.

Assets + Drawings = Capital + Liabilities

Bank Vehicle Inventory = Capital Payable
13,000 12,000 3,000 = 25,000 + 3,000
-500 + +500 = 25,000 + 3,000
12,500 12,000 3,000 + 500 = 25,000 + 3,000

Oct 22 Paid Ali $800 on account by cheque.

This payment will decrease the bank account balance and the amount owed to
Ali.

Assets + Drawings = Capital + Liabilities

Bank Vehicle Inventory = Capital Payable
12,500 12,000 3,000 + 500 = 25,000 + 3,000
-800 = -800
11,700 12,000 3,000 + 500 = 25,000 + 2,200

Observations

 All transactions have two effects.

 If the effects are of the same side of the accounting equation, they have to
be of alternate signs (+ and -).
 If the transaction affects items on different sides of the accounting
equation, they have to be of the same signs (+ and+ or - and -) to keep the
accounting equation balanced.

Activity

1*. Write the accounting equation for the following transactions

20X8

Oct 1 Anjeli commenced business by depositing $35,000 in a bank account.

Oct 4 Furniture costing $5,000 was purchased by cheque.

Oct 10 Goods for resale costing $4,000 were purchased on credit from Ken.

Oct 20 The owner withdrew $700 from the business bank account for her

personal use.

Oct 22 Paid Ken $800 on account by cheque.

2. Complete the gaps in the following table:

Assets Liabilities Capital

$ $ $
(a) 26,500 3,670 ?
(b) 14,333 ? 9,505
(c) ? 4,490 12,660
(d) 54,337 ? 38,990
(e) 29,001 ? 27,555
(f) 9,560 58 ?

3. *Classify the following items into assets and liabilities:

1. Land and Buildings

2. Loan from bank
3. Trade payables
4. Cash in hand
5. Motor car
6. Stocks of goods

4. Complete the gaps in the following table:

Assets Liabilities Capital

$ $ $
(a) 1,143 564 ?
(b) ? 7,868 24,684
(c) ? 43,244 130,990
(d) 56,826 ? 14,512
(e) 98,693 21,414 ?
(f) 77,657 ? 22,193

5. Which of the following are shown under the wrong headings?

Assets Liabilities
Stocks of goods for resale Cash in till
Amounts due on stocks purchased Amounts owing to firm by trade
receivables
Loan made by the firm to another firm Loan
Bank overdraft
Machinery
Answer to activities

Activity 2

Liabilities Capital
Assets

26,500 3,670 22,830

14,333 4,828 9,505

17,150 4,490 12,660

54,337 15,347 38,990

29,001 1,446 27,555

9,560 58 9,502

4.

Assets Liabilities Capital

$ $ $

(a) 1,143 564 579

(b) 32,552 7,868 24,684

(c) 174,234 43,244 130,990

(d) 56,826 42,314 14,512

(e) 98,693 21,414 77,279

(f) 77,657 55,464 22,193

Activity 5

The following were under the wrong headings:

 Amounts due on stocks purchased

 Loan made by the firm to another firm

 Bank overdraft

 Amounts owing to firm by trade receivables

 overdraft