TOPIC 2 Elements of Accounting and Accounting Equation

TOPIC 2.
ELEMENTS OF ACCOUNTING AND

ACCOUNTING EQUATION
LEARNING AUTCOMES:
know and explain the basic accounting equation;
define and understand the notion of assets, liabilities, revenues, expenses and costs;
classify the elements of assets and liabilities;
differentiate between costs and expenses;
know and explain the direct material costs, direct personnel costs and indirect production
costs.
2.1. Basic Accounting Equation

Accounting is an information system that measures processes and communicates
financial information about economic activity of an entity. Financial position is the state of and
the relationships among the various financial data found on an entity's balance sheet. For
example, a company with fairly valued and relatively liquid assets, combined with a small
amount of debt compared to owner's equity, is generally described as being in a strong
financial position. Also called financial condition.
To make an accounting measurement, the accountant must answer the basic question:
What is measured? This answer we can find studying such notion as business transaction.
Business transactions are economic events that affect the financial position of an entity;
transactions are recorded by accountants in documents.
A transaction can be an exchange of value (a purchase, sale, payment, collection, or
loan) between two or more independent parties.
All business transactions are recorded in terms of money. This concept is termed money
measure.
Financial position refers to the economic resources that belong to an entity and the
claims against those resources at a point in time. Another term for claims is equities.
Therefore, an entity can be viewed as composed of economic resources and equities, which
always should be in balance.
Economic resources = Equities
Every entity has two types of equities:
 Creditor’s Equities. Creditor’s Equities are legal obligations for the future payment of
assets or the future performance of services that result from past transactions. Among
these obligations are debts of the business, amount owed to suppliers for goods or
services bought on credit (accounts payable), borrowed money (for example, money
owed on loans payable to banks), salaries and wages owed to employees, taxes owed to
the government, and services to be performed.
 Owner’s Equities. Owner’s Equity represents the claims by the owner of a business to
the assets of the business. It equals the residual interest, or residual equity, in the assets
of an entity that remains after deducting the entity’s liabilities. Theoretically, it is what
would be left if all the liabilities were paid, and it is sometimes said to equal net assets.
Economic resources = Creditor’s Equities + Owner’s Equities
In accounting terminology, economic resources are called assets and creditor’s equities
are called liabilities. So, the equation can be written like this:
Assets = Liabilities + Owner’s Equity
This equation is known as the accounting equation. The two sides of the equation
always must be equal, or in balance.
Buy rearranging the accounting equation, we can define owner’s equity this way:
Owner’s Equity = Assets – Liabilities
2.2. Assets classification

Assets are things that the entity owns. They are the resources that are expected to
benefit future operations.
The assets of a Moldovan entity are usually divided into two major categories:
 long-term assets and
 current (short term) assets.
The long-term category includes intangible assets, tangible assets, and financial assets.
The current assets category includes inventories, receivables, investments, and cash.
Intangible assets
Long-term
Tangible assets
assets
Financial assets
Assets
Inventories
Receivables
Current assets
Investments
Cash
Intangible assets are easily identifiable non-monetary assets without physical

substance that are controlled by an enterprise, and are expected to be used during more than
one reporting period, and are used in the production or supply of goods, etc., for rental to
others, or for administrative purposes (patents, licenses, trademarks, software, etc.).
Long-term tangible assets are assets with physical natural substance with a useful life
of more than a year used by the enterprise, or which are being constructed, that are not held
for sale (tangible assets in process, land, fixed assets and natural resources).
Long-term financial assets are long-term investments in other enterprises, and in

securities, and receivables of maturity above one year.
Current assets
Current assets are those assets of an entity that are reasonably expected to be realized
in cash, sold or consumed during one year or during the normal operating cycle of the
business.
Inventories may be classified as follows; materials, low-value and short-life items,
work in-process, finished products, merchandise.
Investments are assets held by enterprises for the accretion of their financial wealth
through receiving income (interest, royalty, dividends, rentals) that results in capital
appreciation or other benefits to the enterprise such as those obtained through trading
relationships.
Receivables (debtors) include all of an entity’s claims for money, goods, services, and
other non-cash assets from other entities. Depending on the economic content receivables are
classified as:
 Trade receivables, including notes receivable and interest;
 Receivables in related parties (subsidiaries, associates, and other enterprises);
 Receivables on settlements with the budget;
 Receivables from employees.
Other Assets is a category some entities use for miscellaneous assets that are not
specified elsewhere on the balance sheet. Other entities group under this heading investments,
intangible assets, and all the other assets owned by a company other than current and fixed
assets.
2.3. Owner’s Equity and Liabilities classification

Liabilities are amounts own to creditors for a past transaction. They are settled over
time through the transfer of economic benefits including money, goods or services. Along with
owner's equity, liabilities can be thought of as a source of the entity's assets.
They can also be thought of as a claim against an entity's assets.
Liabilities represent:
 debts of the business,
 amounts owed to suppliers for goods or services bought on credit (called accounts
payable),
 borrowed money (for example, credits, loans),
 salaries and wages owed to employees,
 taxes owed to the government and others.
Recorded on the balance sheet (right side), liabilities include loans, accounts payable,
mortgages, deferred revenues and accrued expenses. Liabilities are a vital aspect of an entity's
operations because they are used to finance operations and pay for large expansions.
Outside of accounting and finance this term simply refers to any money or service that
is currently owed to another party. One form of liability, for example, would be the
property taxes that a homeowner owes to the municipal government.
On the Balance Sheet liabilities are divided in two groups:
1. Long-term liabilities - are debts payable over a longer period.
2. Current liabilities - are debts payable within one year.
Owner’s Equity represents the claims by the owner of a business to the assets of the
business. It equals the residual interesting - the assets of an enterprise that remains after
deducting the entity’s liabilities.
Owner’s Equity = Assets – Liabilities = Net Assets
2.4. Revenues, Expenses and Costs classification

Revenue is the gross inflow of economic benefits during the reporting period arising in
the course of the ordinary activities of an enterprise when those inflows result in increases in
assets, or decrease in liabilities causing an increase in owner’s equity other than increases
related to contributions from equity participants.
Cost stands for materials and resources consumed in the process of manufacturing outputs
and providing services with the purpose of generating revenues.
Direct costs are those costs which might be directly identified with and traced to a specific
product or to a cost object. Indirect costs are those costs that cannot be traced to a specific
product or to a cost object.
Variable costs are constantly changing in proportion to gross output (products and services).
Fixed costs are constant within a certain range of fluctuations irrespective of changes in the
volume of production or business activity of management.
Direct material costs are cost of raw materials and supplies, and semi-finished products used
in the manufacturing process that are a physical integral part of the manufactured product and
are directly included in manufacturing cost of these products.
Direct labor costs are expenses for wages of workers directly related to the cost of finished
products; for service enterprises the term labor costs is used.
Indirect manufacturing costs are material costs and labor costs that can not be directly
identified as manufacturing cost and are allocated indirectly in the cost of the product.
Expenses comprise all losses taken into account in the calculation of the profit for the
period, which are deducted from revenue.
SELF-ASSESSMENT QUESTIONS
1. What are the assets of the entity?

2. What are the entity's liabilities?
3. What are the differences between costs and expenses? Define them.
4. What is included in direct material costs? Give examples.
5. What are the particularities of costs?
6. How do direct and indirect production costs differ?
7. What are variable costs and constant costs?

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TOPIC 2.

ELEMENTS OF ACCOUNTING AND

2.1. Basic Accounting Equation

2.2. Assets classification

Intangible assets are easily identifiable non-monetary assets without physical

Long-term financial assets are long-term investments in other enterprises, and in

2.3. Owner’s Equity and Liabilities classification

2.4. Revenues, Expenses and Costs classification

1. What are the assets of the entity?

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