CHAPTER 2

The Accounting equation

Lecturer: Hyungjin Cho

hcho@emp.uc3m.es

1
Chapter outline

 The value of the company

 The accounting equation

 Analysis of business transactions

 Profit and loss account

 Balance sheet

 Cash flow statement

2
 The value of the company:
Owners´Equity

Assets – liabilities= Owners´equity

Owners´equity is the amount of an

entity´s assets that remain after its
liabilities are substracted
The purpose of a business is to
increase owners´equity.
3
 The Accounting Equation

 The accounting equation presents the

resources of the business and the
claims to those resources

Economic Resources = Claims to Economic Resources

or
Assets = Liabilities + Owners’ Equity

4
The Accounting Equation

 Assets are the economic resources of

a business that are expected to be of
benefit in the future
 Claims to assets come from
 Liabilities
• Economic obligations - debts payable to
outsiders, called creditors
 Owners’ equity (capital)
• Assets held by the owners of the
business
5
 The Accounting Equation

 For a corporation, stockholders’

(owners’) equity consists of two main
categories
 Paid-in capital
 Retained earnings

Assets = Liabilities + Stockholders’ Equity

or
Assets = Liabilities + Paid-in Capital + Retained Earnings
6
 Accounting Equation Elements
(PGC)
 Assets: goods, rights and other resources controlled by the
company as a result of past events and from which future
economic benefits are expected to flow to the company.

 Liabilities: present obligations of the company arising from

past events, the settlement of which is expected to result in an
outflow of resources from the company embodying future
economic benefits. Liabilities shall include provisions.

 Equity: the residual interest in the assets of the company after

deducting all its liabilities. Equity includes contributions made
by equity holders or owners upon incorporation of the company
or subsequently that are not considered as liabilities, as well as
retained earnings and cumulative losses or other related
variations.
 The Accounting Equation

 Paid-in (contributed) capital is

 The amount invested in the corporation by its
owners
 Comprises basically of common stock

8
 The Accounting Equation

 Retained earnings
 Is the amount earned by income-producing
activities and kept for use in the business
 Is affected by
• Revenues - increases in retained earnings from
delivering goods or services
• Expenses - decreases in retained earnings that result
from operations

9
Transactions that Affect
Owners´Equity

10
The Accounting Equation

 Net income (net earnings)

 Total revenues exceed total expenses
 Net loss
 Total expenses exceed total revenues
 Dividends
 Distributions to stockholders (usually
cash) generated by net income

11
 Components of Retained
Earnings
Revenues for the
Period

Expenses for the

Period

Start of the = End of the

Period Period

Beginning Balance + Ending Balance of

Net Income (Loss) - Dividends for the =
of Retained - Retained
for the Period Period
Earnings Earnings

12
 The accounting equation
 Assets = liabilities
 Assets = liabilities + capital
 Assets = liabilities + capital + profit (revenues-expenses)
 Assets +expenses = liabilities + capital + Revenues

Debit T account Credit

Assets and expenses on
Revenues, liabilities and
left hand side
capital on right hand side

13
 Illustrating the Accounting Equation
A firm starts the year with €10,000 assets and €10,000 liabilities (€6,000 third party
liabilities and €4,000 owner’s capital). During the year, the firm makes €5,000 profit
(€9,000 revenues, €4,000 expenses). Show how the accounting equation works.
Accounting equation Transaction

1) Assets=liabilities €10,000= €10,000

2) Assets = liabilities + capital €10,000=€6,000+€4,000

3) Assets = liabilities + capital + profit €15,000= €6,000+€4,000+€5,000

4) Assets = liabilities + capital + (revenues- €15,000= €6,000+€4,000+ (€9,000-

expenses) €4,000)

5) Assets + expenses = liabilities + capital + €15,000+ €4,000=

revenues 14 €6,000+€4,000+€9,000
 Accounting terms
Can you think of examples of revenues, expenses, assets and
liabilities which a typical business may have?

Revenue Expenses Assets Liabilities

Sales of goods Telephone Buildings Bank loan

Sales of assets Business rates Motor cars Creditors

Bank interest Electricity Furniture Bills owing

earned
Repairs Stock

Petrol consumed Debtors

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 Assets

 Current assets are

 Those assets which the company expects to convert to
cash, sell, or consume during the next 12 months or within
the business's normal operating cycle if longer than a year
 Current assets include
 Cash
 Accounts receivable
 Merchandise inventory
 Prepaid expenses
 Short-term investment

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 Assets

 Long-term assets are

 Those assets which the company expects to hold longer
than the next 12 months or the business’s normal operating
cycle if longer than one year
 Long-term assets include
 Property, Plant and Equipment
 Long-term investment
 Intangible assets (patent, R&D ..)

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Assets

 Intangible assets are

 Those with no physical form
• Trademarks
• Patents
 Other assets are
 Those with small values which do not fall
within any other standard asset category

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Liabilities

 Current liabilities are

 Debts payable within one year or within
the business’s normal operating cycle if
longer than a year
 Current liabilities include
 Notes payable, short term
 Accounts payable
 Accrued expenses payable
 Income taxes payable
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Liabilities

 Long-term liabilities are

 Debts not payable within one year or within
the business’s normal operating cycle if
longer than a year
 Long-term liabilities include
 Notes payable, long term
 Bonds payable

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Owners’ Equity

 Owners’ equity
 Represents the shareholders’ ownership of
the assets of the business
 Owners’ equity of a corporation
consists of
 Common stock (or capital)
 Retained earnings (or reserves)
 Profits

21
 Transactions

 A transaction is any event that

 affects the financial position of the business entity
 can be measured reliably
 Transactions involve give-get exchanges
 Give merchandise
 Get cash
 Transactions must be stated in monetary terms to
be entered in books

22
Accounting for Business
Transactions

Consider the following transactions for

Air & Sea Travel, Inc., and their effect
on the accounting equation

23
 Accounting for Business
Transactions
TRANSACTION 1
The owners invest $50,000 of their money to begin
the business, and Air & Sea Travel issues common
stock to them
Assets = Liabilities + Stockholders' Equity
Cash Common Stock
(1) +50,000 +50,000

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 Accounting for Business
Transactions
TRANSACTION 2
Air & Sea Travel purchases land for a future office
location, paying cash of $40,000

Assets Liabilities + Stockholders' Equity

Cash + Land Common Stock
(1) 50,000 = +50,000
(2) -40,000 + 40,000 _______
10,000 40,000 50,000

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 Accounting for Business
Transactions
TRANSACTION 3
The business buys stationery and other office
supplies, agreeing to pay $500 to the office-supply
store within 30 days
Assets Liabilities + Stockholders' Equity
Office Accounts
Cash + Supplies + Land Payable + Common Stock
Bal. 10,000 40,000 = 50,000
(3) _____ +500 _____ +500 _____
Bal. 10,000 500 40,000 500 50,000

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 Accounting for Business
Transactions
TRANSACTION 4
Air & Sea Travel earns service revenue of $5,500
and collects this amount in cash

Assets Liabilities + Stockholders' Equity

Office Accounts Retained
Cash + Supplies + Land Payable + Common Stock + Earnings
Bal. 10,000 500 40,000 = 500 50,000
(4) +5,500 _____ _____ _____ _____ +5,500
Bal. 15,500 500 40,000 500 50,000 5,500

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 Accounting for Business
Transactions
TRANSACTION 5
Air & Sea Travel performs services for customers on
account for $3,000

Assets Liabilities + Stockholders' Equity

Accounts Office Accounts Retained
Cash + Receivable + Supplies + Land Payable + Common Stock + Earnings
Bal. 15,500 500 40,000 = 500 50,000 5,500
(5) _____ +3,000 _____ _____ _____ _____ +3,000
Bal. 15,500 3,000 500 40,000 500 50,000 8,500

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 Accounting for Business
Transactions
TRANSACTION 6
Air & Sea Travel pays $2,700 for the following cash
expenses: office rent $1,100, employee salary
$1,200, and utilities $400
Assets Liabilities + Stockholders' Equity

Accounts Office Accounts Retained

Cash + Receivable + Supplies + Land Payable + Common Stock + Earnings

Bal. 15,500 3,000 500 40,000 500 50,000 8,500

(6) -1,100 = -1,100

-1,200 -1,200

-400 _____ _____ _____ _____ _____ -400

Bal. 12,800 3,000 500 40,000 500 50,000 5,800

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 Accounting for Business
Transactions
TRANSACTION 7
Air & Sea Travel pays $400 to the store from which it
purchased $500 worth of office supplies in
Transaction 3
Assets Liabilities + Stockholders' Equity

Accounts Office Accounts Retained

Cash + Receivable + Supplies + Land Payable + Common Stock + Earnings

Bal. 12,800 3,000 500 40,000 = 500 50,000 5,800

(7) -400 _____ _____ _____ -400 _____ _____

Bal. 12,400 3,000 500 40,000 100 50,000 5,800

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 Accounting for Business
Transactions
TRANSACTION 8
The owners remodel their home at a cost of
$30,000, paying cash from personal funds

This event is a transaction of the personal

entity, not the business entity
No transaction is recorded for Air & Sea Travel

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 Accounting for Business
Transactions
TRANSACTION 9
The business collects $1,000 from a customer on
account

Assets Liabilities + Stockholders' Equity

Accounts Office Accounts Retained

Cash + Receivable + Supplies + Land Payable + Common Stock + Earnings

Bal. 12,400 3000 500 40,000 = 100 50,000 5,800

(9) +1,000 -1,000 _____ _____ _____ _____ _____

Bal. 13,400 2000 500 40,000 100 50,000 5,800

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 Accounting for Business
Transactions
TRANSACTION 10
Air & Sea Travel sells land for a price of $22,000,
which is equal to the amount it paid for the land

Assets Liabilities + Stockholders' Equity

Accounts Office Accounts Retained

Cash + Receivable + Supplies + Land Payable + Common Stock + Earnings

Bal. 13,400 2,000 500 40000 = 100 50,000 5,800

(10) +22,000 _____ _____ -22,000 _____ _____ _____

Bal. 35,400 2,000 500 18000 100 50,000 5,800

33
 Accounting for Business
Transactions
TRANSACTION 11
The corporation declares a dividend and pays
$2,100 cash to the stockholders

Assets Liabilities + Stockholders' Equity

Accounts Office Accounts Retained

Cash + Receivable + Supplies + Land Payable + Common Stock + Earnings

Bal. 35,400 2,000 500 18,000 = 100 50,000 5,800

(11) -2,100 _____ _____ _____ _____ _____ -2,100

Bal. 33,300 2,000 500 18,000 100 50,000 3,700

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 Analysis of Transactions

Assets Liabilities + Stockholders' Equity

Accounts Office Accounts Retained

Cash + Receivable + Supplies + Land Payable + Common Stock + Earnings

(1) +50,000 +50,000

(2) -40.000 +40,000

(3) +500 +500

(4) +5,500 +5,500

(5) +3,000 +3,000

(6) -1.100 = -1.100

-1.200 -1.200

-400 -400

(7) -400 -400

(8) Not a transaction of the business

(9) +1,000 -1.000

(10) +22,000 -22.000

(11) -2.100 _____ _____ _____ _____ _____ -2.100

Bal. 33.300 2.000 500 18.000 100 50.000 3.700

35Flow Data
Statement of Cash Balance Sheet Data
 Exam Question Type

If liabilities increase by $120,000 during a given period and

stockholders´ equity decreases $25,000 during the same
period, assets must:

a. decrease $145,000
b. increase $145,000
c. decrease $95,000
d. increase $95,000

36
 Exam Question Type

If liabilities increase by $120,000 during a given period and

stockholders´ equity decreases $25,000 during the same
period, assets must:

a. decrease $145,000
b. increase $145,000
c. decrease $95,000
d. increase $95,000

37
 Exam Question Type
Which of the following transactions would increase assets?

I. Borrowed cash on a note payable, $50,000

II.Provided services on account, $6,000
III. Received cash from a customer as payment on account, $2,000
IV. Received a utility bill, $500

a. I and II
b. I and III
c. I, II, and III
d. All of these answers are correct.

38
 Exam Question Type
Which of the following transactions would increase assets?

I. Borrowed cash on a note payable, $50,000

II.Provided services on account, $6,000
III. Received cash from a customer as payment on account, $2,000
IV. Received a utility bill, $500

a. I and II
b. I and III
c. I, II, and III
d. All of these answers are correct.

39
 Exam Question Type

The payment of an amount owed to a creditor would:

a. increase assets
b. increase liabilities
c. decrease net income
d. decrease liabilities

40
 Exam Question Type

The payment of an amount owed to a creditor would:

a. increase assets
b. increase liabilities
c. decrease net income
d. decrease liabilities

41
 INFORMATION REPORTED ON THE
FINANCIAL STATEMENTS

•Profit and loss account (Income statement)

•Statement of Retained Earnings
•Balance Sheet
•Cash flow statement
42
 Question Answer Financial Statement
1. How well did the Revenues Income statement
company perform -Expenses (Statement of
during the period? Net income (loss) operations or
Statement of
earnings)

2. Why did the Beginning R.E. Statement of retained

company’s retained +Net income (-loss) earnings (Statement
earnings change -Dividends of stockholders’
during the period? Ending R.E. equity)

3. What is the Assets = Liabilities + Balance sheet

company’s financial Owners’ (Statement of
position at the end of Equity financial position)
the period?

4. How much cash did Operating cash flows Statement of cash

the company + Investing cash flow flows
generate and spend +Financing cash flow
during the period? Increase (decrease)
in cash during the
period
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Income Statement

 The income statement (statement of

earnings) reports the company’s
revenues, expenses, and net income
or net loss for the period

Shows revenue earned less expenses

incurred, gives profit over a period of
time

44
 Financial Statements of
AIR & SEA TRAVEL, INC.

AIR & SEA TRAVEL, INC.

Income Statement
Month Ended April 30, 2001

Revenue:
Service revenue $8,500

Expenses:
Salary expense $1,200
Rent expense 1,100
Utilities 400
Total expenses 2,700
Net Income $5,800
45
Income Statement

 Revenues are
 Increases in retained earnings from
delivering goods or services to
customers or clients
 Expenses are
 Decreases in retained earnings that
result from operations

46
 Income Statement (PGC)
Income or Revenues: increases in the company’s equity
during the reporting period in the form of inflows or
enhancements of assets or decreases in liabilities, other
than those relating to monetary or non-monetary
contributions from equity holders or owners.

Expenses: decreases in equity during the reporting

period in the form of outflows or depletions of assets or
incurrences of liabilities, other than those relating to
monetary or non-monetary distributions to equity
holders or47 owners.
Income Statement

 Expenses include
 Cost of goods sold (cost of sales)
• The cost of the goods that a company
sold to its customers
 Operating expenses
• The costs of operating the business

48
Income Statement
 Operating expenses
 Advertising
• The cost to promote the company’s products
 Depreciation
• The expense of using company-owned
buildings, equipment, and furniture
 Other operating expenses
• The costs of salaries, utilities, rent, and
supplies
 Interest expense
• The cost of borrowed money
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Statement of Retained
Earnings
 The statement of retained earnings
reports that portion of net income the
company has retained, or kept for use
in the business
 Net income increases retained
earnings
 Dividends paid to stockholders
decrease retained earnings

50
 Financial Statements of
AIR & SEA TRAVEL, INC.
AIR & SEA TRAVEL, INC.
Statement of Retained Earnings
Month Ended April 30, 2001

Retained earnings, April 1, 2001 $ 0

Add: Net income for the month 5,800
$5,800
Less: Dividends (2,100)
Retained Earnings, April 30, 2001 $3,700

51
Balance Sheet

 The balance sheet (statement of

financial position) reports the
company’s assets, liabilities, and
owners’ equity

Shows assets, liabilities and capital at

point in time

52
 Financial Statements of
AIR & SEA TRAVEL, INC.

AIR & SEA TRAVEL, INC.

Balance Sheet
April 30, 2001

Assets Liabilities

Cash $33,300 Accounts payable $ 100

Accounts receivable 2,000
Office supplies 500 Stockholders’ Equity
Land 18,000 Common stock 50,000
Retained earnings 3,700
Total stockholders’ equity 53,700
_______ Total liabilities and
Total assets
53
$53,800 stockholders’ equity $53,800
Statement of Cash Flows

 The statement of cash flows reports

the company’s cash inflows and
outflows from operating, investing,
and financing activities

Shows cash received and paid over a

period of time
54
 AIR & SEA TRAVEL, INC.
Statement of Cash Flows
Month Ended April 30, 2001

Cash flows from operating activities:

Collections from customers $ 6,500
Payments to suppliers and employees (3,100)
Net cash inflow from operating activities 3,400
Cash flows from investing activities:
Acquisition of land $(40,000)
Sale of land 22,000
Net cash outflow from investing activities (18,000)
Cash flows from financing activities:
Issuance (sale) of stock $ 50,000
Payment of dividends (2,100)
Net cash inflow from financing activities 47,900
Net increase in cash $ 33,300
Cash balance, April 1, 2001 0
Cash balance,
55 April 30, 2001 $ 33,300
 Statement of Cash Flows
 Operating activities
 Companies operate by buying goods and
services, which are sold to customers
 Investing Activities
 Companies invest in long-term assets that are
used to run the business
 Financing Activities
 Companies finance themselves by issuing stock
and borrowing money

56
 Relationship Among the
Financial Statements
 Income statement is completed first
 Statement of retained earnings requires net
income to calculate an ending balance
 Balance sheet requires the ending balance of
retained earnings to balance
 Statement of cash flows reports increases and
decreases in cash and must agree with the
cash balance on the balance sheet
57
 AIR & SEA TRAVEL, INC.
Statement of Cash Flows AIR & SEA TRAVEL, INC.
Month Ended April 30, 2001 Income Statement
Month Ended April 30, 2001
Cash flows from operating activities:
Collections from customers $ 6,500 Revenue:
Payments to suppliers and employees (3,100)
Net cash inflow from operating activities 3,400
Service revenue $8,500
Cash flows from investing activities:
Acquisition of land $(40,000) Expenses:
Sale of land 22,000 Salary expense $1,200
Net cash outflow from investing activities (18,000) Rent expense 1,100
Cash flows from financing activities: Utilities 400
Issuance (sale) of stock $ 50,000 Total expenses 2,700
Payment of dividends (2,100)
Net Income $5,800
Net cash inflow from financing activities 47,900
Net increase in cash $ 33,300
Cash balance, April 1, 2001 0
Cash balance, April 30, 2001 $ 33,300
AIR & SEA TRAVEL, INC.
Balance Sheet
AIR & SEA TRAVEL, INC. April 30, 2001
Statement of Retained Earnings Assets Liabilities
Month Ended April 30, 2001
Cash $33,300 Accounts payable $ 100
Accounts receivable 2,000
Retained earnings, April 1, 2001 0 $ Office supplies 500 Stockholders’ Equity
Add: Net income for the month 5,800 Land 18,000 Common stock 50,000
Retained earnings 3,700
$5,800 Total stockholders’ equity 53,700
Less: Dividends (2,100) _______ Total liabilities and _______
Retained Earnings, April 30, 2001 $3,700 Total assets $53,800 stockholders’ equity $53,800

58
 Merchandising company
Service Co. Merchandising Co.
Income Statement Income Statement
Year ended June 30, 20XX Year Ended June 30, 20XX

Service revenue $ xx x Sales revenue $ xxx

Expenses Cost of goods sold x
Salary expense x Gross profit x
Depreciation expenses x Operating expenses:
Salary expense x
Depreciation expense x
Income tax expense x
Net income $ x
Income tax expense x
Net income $ x
Service Co.
Balance Sheet
June 30, 20XX
Merchandising Co.
ASSETS Balance Sheet
Current assets: June 30, 20XX
Cash $ x
Short-term investments x ASSETS
Accounts receivable, net x Current assets:
Prepaid expenses x Cash $ x
Short-term investments x
Accounts receivable x
Inventory x
Prepaid expenses x

59
 Learning Outcomes

 Using accounting equation to describe an

organization
 Evaluating operating performance and financial
position of a company
 Analysing business transactions
 How is information shown in the financial
statements
 Explaining relationships among the financial
statements
60