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Accounting Equation(Service business)

Waikato Legal Services

Mary LowWaikato Management SchoolThe University of Waikato

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The framework

The accounting equation can be said to the framework for the entire accounting process.

The accounting equation is an essential building block of accounting.

The accounting equation is the basis of all accounting systems.

The accounting equation can be used to illustrate simply the double entry system of accounting.

The two sides of the equation must be equal.

The accounting equation is also called the balance sheet equation.

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The basic elementsThe two basic elements of any organisation are what it owns and what it owes.

What it owns are the organisation’s economic resources. These economic resources are used to help the organisation generate revenues. In accounting, these economic resources are called ASSETS.

Examples of assets for an organisation are:

• Cash

• Inventory

• Accounts Receivable

• Land & Buildings

• Motor Vehicle

• Furniture & Equipment

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The basic elements – what it owesWhat it owes are the organisation’s sources of financing for the economic resources.

The main source of financing usually comes from EQUITY. Equity indicates the amount of financing provided by owners of the organisation.

The next source of financing comes from debt. Debt is the result of the organisation purchasing goods, services or assets on credit. Debt also results from loan borrowings. Debt is given the term LIABILITIES.

Examples of equity for an organisation are:

• Owner’s Equity / Proprietorship for a sole trader business

• Partnership Funds for a partnership business

• Shareholders Equity for a company business

Examples of liabilities for an organisation are:

• Accounts Payable

• Loan Payable

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The accounting equationwhat it owns = what it owes

Assets = Liabilities + Equity

A Balance Sheet (Statement of Financial Position) shows that the assets of an organisation should equal to its liabilities plus equity.

This is why the accounting equation is also called a balance sheet equation.

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Different versions of the accounting equation

The accounting equation can be expressed in a number of different ways:

Asset emphasis:•Assets = Liabilities + Equity

Liability emphasis:•Liabilities = Assets – Equity

Equity emphasis:•Equity = Assets - Liabilities

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Running a business - its main objective

• Businesses usually operate with the objective of making a profit.

• Profit is determined by looking at two other elements.

• These financial elements relate to revenue (income) and expenses

• Profit is determined by subtracting expenses from revenues (income)– i.e. Profit = Revenue - Expenses

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Profit

• Any profits made by a business will go to the owner. Therefore, revenue (income) and expenses effects are usually shown under the Equity section of the accounting equation. An increase in revenues represents an increase in profit and therefore an increase in Equity. An increase in expenses represents a decrease in profits and therefore a decrease in Equity.

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Transaction 1

• Transaction 1: Investment by owner. Ace Lawyer opens the Waikato Legal Services firm in Hamilton by investing $20,000 cash into the business.

• The transaction results in an increase in the Cash Asset and an increase in Equity.

• We note that the equation remains in balance, – i.e. A = L + OE

Assets = Liabilities + Owner’s Equity

Cash Capital

+$20,000 +$20,000

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Transaction 2• Transaction 2: Purchase of equipment on credit. Ace purchases

equipment on credit from Computer Equipment Ltd for $9,000 (credit terms: 180 days).

• The transaction results in an increase in the Computer Equipment Asset and an increase in Liability.

• We note that the equation remains in balance, – i.e. A = L + OE

Assets = Liabilities + Owner’s Equity

Cash + Equipment Accounts Payable

Capital

Old bal. $20,000 $20,000

Trans 2: + $9,000 +$9,000

New bal. $20,000 + $9,000 = $9,000 + $20,000

Total: $29,000 = $29,000

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Transaction 3• Transaction 3: Purchase of $1,500 of stationery supplies for use in the

business. $1,500 cash was used to pay for this purchase.• The transaction results in an increase in Supplies on Hand Asset and a

decrease in the Cash Asset.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Equipment

on Hand

Accounts Payable

Capital

Old bal. $20,000 + $9,000 = $9,000 + $20,000Trans 3: - $1,500 + $1,500 New bal. $18,500 + $1,500 + $9,000 = $9,000 + $20,000Total: $29,000 = $29,000

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Important Note:There are two ways that we can choose to record stationery supplies.

1. We can record the supplies initially as an asset until they become used up. When supplies on hand become used up, they should then be recorded as an increase to Stationery Supplies Expense. When this happens, we will need to decrease Stationery Supplies Asset and decrease Equity. Because we do not have a separate expense heading in the accounting equation: A = L + OE, expenses will need to be deducted from Capital.This first approach has been chosen in this illustration to explain the effects on the accounting equation where stationery supplies are initially purchased for use in the business.

2. Stationery supplies can initially be recorded as an expense. For this illustration, the effect of this second approach will be to initially decrease Equity (Expenses decrease Equity) and to decrease cash Asset. At the end of the accounting period, the amount of stationery supplies that is on hand (not used up) will need to be recorded as an asset. To record the unused supplies, Stationery Supplies Expense will need to be decreased (note: to show an expense decrease in the accounting equation: A = L + OE, Equity will need to be increased) and Supplies on Hand Asset will need to be increased.

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Transaction 4• Transaction 4: $1,000 in legal services were provided for cash. • We can straight away see that the transaction results in an increase in the

Cash Asset by $1,000 and an increase in the Legal Services Revenue account by $1,000.

• We note that the equation does not have Revenue heading, – i.e. the equation is given as: A = L + OE

• As we explained earlier, the effect of a revenue increasing will need to be shown as an increase in Equity.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Equipment

on Hand

Accounts Payable

Capital

Old bal. $18,500 + $1,500 + $9,000 = $9,000 + $20,000

Trans 4: +$1,000 +$1,000

New bal. $19,500 + $1,500 + $9,000 = $9,000 + $21,000

Total: $30,000 = $30,000

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Transaction 5• Transaction 5: Legal services of $2,500 were provided on credit to a

client, Keith Queen.

• The transaction results in an increase in an Account Receivable Asset by $2,500. Keith Queen owes $2,500 to Waikato Legal Services. He is an Account Receivable and therefore recorded as an asset to the business. Although no cash has been received from providing legal services, $2,500 of Legal Services Revenue have been earned (Accrual concept) and will increase Equity.

Assets = Liabilities + Owner’s Equity

Cash + Accounts Receivable + Supplies +Equipment

on Hand

Accounts Payable

Capital

Old bal. $19,500 + $1,500 + $9,000 = $9,000 + $21,000

Trans 5: + $2,500 +$2,500

New bal. $19,500 + $2,500 + $1,500 + $9,000 = $9,000 + $23,500

Total: $32,500 = $32,500

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Transaction 6• Transaction 6: Paid Accounts Payable. Ace makes a

$3,000 partial debt repayment to Computer Equipment Ltd.

• The transaction results in a decrease to Cash Asset and a decrease to Accounts Payable Liability.

Assets = Liabilities + Owner’s Equity

Cash + Accounts Receivable + Supplies +Equipment

on Hand

Accounts Payable

Capital

Old bal. $19,500 + $2,500 + $1,500 + $9,000 = $9,000 + $23,500

Trans 6: -$3,000 - $3,000

New bal. $16,500 + $2,500 + $1,500 + $9,000 = $6,000 + $23,500

Total: $29,500 = $29,500

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Transaction 7• Transaction 7: Received from Accounts Receivable.

Keith Queen pays $500 on account owing to Waikato Legal Services

• The transaction results in an increase to Cash Asset and a decrease to the Accounts Receivable Asset.

Assets = Liabilities + Owner’s Equity

Cash + Accounts Receivable + Supplies +Equipment

on Hand

Accounts Payable

Capital

Old bal. $16,500 + $2,500 + $1,500 + $9,000 = $6,000 + $23,500

Trans 7: + $500 - $500

New bal. $17,000 + $2,000 + $1,500 + $9,000 = $6,000 + $23,500

Total: $29,500 = $29,500

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Transaction 8• Transaction 8: Drawings by Ace Lawyer. Ace decides to take $2,000

cash from the business for his personal use.

• The transaction results in a decrease to Cash Asset and a decrease to Capital Equity. Any withdrawals of assets by the owner from his business for his personal use will cause a decrease in his investment in the business.

Assets = Liabilities + Owner’s Equity

Cash + Accounts Receivable + Supplies +Equipment

on Hand

Accounts Payable

Capital

Old bal. $17,000 + $2,000 + $1,500 + $9,000 = $6,000 + $23,500

Trans 8: - $2,000 -$2,000

New bal. $15,000 + $2,000 + $1,500 + $9,000 = $6,000 + $21,500

Total: $27,500 = $27,500

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Transaction 9• Transaction 9: Payment of Expense. Ace pays $400

salaries to legal assistant.

• The transaction results in a decrease to Cash Asset and a decrease to Equity because of salaries expense.

Assets = Liabilities + Owner’s Equity

Cash + Accounts Receivable + Supplies + Equipment

on Hand

Accounts Payable

Capital

Old bal. $15,000 + $2,000 + $1,500 + $9,000 = $6,000 + $21,500

Trans 9: - $400 - $400

New bal. $14,600 + $2,000 + $1,500 + $9,000 = $6,000 + $21,100

Total: $27,100 = $27,100

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Transaction 10• Transaction 10: It was determined that $500 of stationery supplies on

hand has been used up.

• The transaction results in a decrease to the Supplies on Hand Asset and a decrease to Equity as a result of supplies becoming used up.

• We note that the equation has remained in balance, – i.e. A = L + OE

Assets = Liabilities

+ Owner’s Equity

Cash + Accounts Receivable + Supplies +Equipment

on Hand

Accounts Payable

Capital

Old bal. $14,600 + $2,000 + $1,500 + $9,000 = $6,000 + $21,100

Trans 10: - $500 - $500

New bal. $14,600 + $2,000 + $1,000 + $9,000 = $6,000 + $20,600

Total: $26,600 = $26,600

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Expanded accounting equation

• The accounting equation can be expanded to include Revenue and Expenses.

We begin with:

Assets = Liabilities + Equity

We bring in the profit element:

Assets = Liabilities + Equity + Profit

Note: Profit = Revenue (Income) – Expenses

Expanded we have:Assets = Liabilities + Equity + Revenue (Income) – Expenses

Which can also be written as:

Assets + Expenses = Liabilities + Equity + Revenue (Income)

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Accounting Equation Analysis• Well, you have done it!• The Waikato Legal Services illustration using the

accounting equation has shown you how to do the following in the accounting process:

– Analyse transactions by identifying the accounts its effects on the main financial elements (Assets, Liabilities, Equity, Revenue (Income) and Expenses) of financial statements

– Showing the effects in the accounting equation and maintaining the equation in balance all the time.

• This is the initial basis of understanding the double entry system without actually learning the debit and credit rules of the double entry system. This comes next if you truly want to understand the accounting system of any organisation.