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Accounting Equation (Perpetual Inventory System)

Hamilton Stationery Shop

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 elements

The 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 equation

what 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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Transaction 1• Transaction 1: Investment by owner. Ray Comic decides

to open a stationery shop 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

Note: The business is not GST registered and therefore there are no GST implications in this illustration.

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

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

• The transaction results in an increase in the 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 stationery inventory for cash. Comic

purchases inventory for resale using $3,000 cash from the business.• The transaction results in an increase in the Inventory Asset and a

decrease in the Cash Asset.• We note that the equation remains in balance,

– i.e. A = L + OE

Assets = Liabilities + Owner’s Equity

Cash + Inventory + Equipment Accounts Payable Capital

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

Trans 3: - $3,000 + $3,000

New bal. $17,000 + $3,000 + $9,000 = $9,000 + $20,000

Total: $29,000 = $29,000

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Transaction 4• Transaction 4: Cash sales of stationery. Comic earns cash sales of

stationery items for $1,000 (cost price of stationery items $400).

• We can straight away see that the transaction results in an increase in the Cash Asset by $1,000 and a decrease in the Inventory Asset by $400.

• We note that the equation will not balance at this stage.

Assets = Liabilities + Owner’s Equity

Cash + Inventory + Equipment Accounts Payable

Capital

Old bal. $17,000 + $3,000 + $9,000 = $9,000 + $20,000

Trans 4: +$1,000 - $400

New bal. $18,000 + $2,600 + $9,000 = $9,000 + $20,000

Total: $29,600 ≠ $29,000

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What have we missed out?• What have we missed out?

• Cash sales represents revenue (income) being earned by Hamilton Stationery Shop. This is another financial element in the accounting process. A business essentially operates to make profits. Profits for a business are determined by subtracting expenses from revenues. Expenses are the costs of operating a business and are usually incurred as a result of generating revenues for the business. Expenses are also a financial element of the accounting process.

• 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 (income) 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.

• Cash sales of $1,000 represent $1,000 increase in Cash Asset as well as $1,000 increase in Sales Revenue (income). This $1,000 in Sales Revenue has to be added to Equity.

• However, in order to earn the $1,000 in sales revenue, what did it cost the business to purchase those stationery items for resale? The information provided tells us that in order to earn $1,000 in sales, the cost price of the stationery items sold was $400. The $400 represent a decrease in Inventory Asset and become an increase in Cost of Goods Sold (or the Cost of Sales). This is the cost or expense related directly to the earning of sales revenue for the business.

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Completion• To complete the accounting equation for transaction 4, we need to

show the Sales Revenue of $1,000 and Cost of Goods Sold expense of $400 effects under Equity.

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

Assets = Liabilities + Owner’s Equity

Cash + Inventory + Equipment Accounts Payable

Capital

Old bal. $17,000 + $3,000 + $9,000 = $9,000 + $20,000

Trans 4: +$1,000 - $400 +$1,000

- $400New bal.

$18,000 + $2,600 + $9,000 = $9,000 + $20,600

Total: $29,600 = $29,600

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Transaction 5• Transaction 5: Credit sales of stationery. Comic sells stationery items for $500

on credit to B. Worm (cost price of stationery items $200).

• The transaction results in an increase in an Account Receivable Asset by $500. B. Worm owes $500 to Hamilton Stationery Shop. He is an Account Receivable and therefore recorded as an asset to the business. The Inventory Asset will decrease by $200. Although no cash has been received from this sale, $500 Sales Revenue (income) have been earned (Accrual concept) and will increase Equity. Cost of Goods Sold, an expense will decrease Equity by $200.

Assets = Liabilities + Owner’s Equity

Cash + Accounts Receivable + Inventory +Equipment Accounts Payable

Capital

Old bal. $18,000 + $2,600 + $9,000 = $9,000 + $20,600

Trans 5: + $500 - $200 +$500

-$200

New bal. $18,000 + $500 + $2,400 + $9,000 = $9,000 + $20,900

Total: $29,900 = $29,900

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

$3,000 partial debt repayment to Waikato 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 + Inventory +Equipment Accounts Payable

Capital

Old bal. $18,000 + $500 + $2,400 + $9,000 = $9,000 + $20,900

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

New bal. $15,000 + $500 + $2,400 + $9,000 = $6,000 + $20,900

Total: $26,900 = $26,900

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Transaction 7• Transaction 7: Received from Accounts Receivable.

B. Worm pays $100 on account owing to Hamilton Stationery Shop.

• 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 + Inventory +Equipment Accounts Payable

Capital

Old bal. $15,000 + $500 + $2,400 + $9,000 = $6,000 + $20,900

Trans 7: + $100 - $100

New bal. $15,100 + $400 + $2,400 + $9,000 = $6,000 + $20,900

Total: $26,900 = $26,900

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Transaction 8• Transaction 8: Drawings by Ray Comic. Ray decides to take $1,000

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 + Inventory +Equipment Accounts Payable

Capital

Old bal. $15,100 + $400 + $2,400 + $9,000 = $6,000 + $20,900

Trans 8: - $1,000 -$1,000

New bal. $14,100 + $400 + $2,400 + $9,000 = $6,000 + $19,900

Total: $25,900 = $25,900

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Transaction 9• Transaction 9: Payment of Expense. Comic pays $200

salaries to shop employee.

• 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 + Inventory +Equipment Accounts Payable

Capital

Old bal. $14,100 + $400 + $2,400 + $9,000 = $6,000 + $19,900

Trans 9: - $200 - $200

New bal. $13,900 + $400 + $2,400 + $9,000 = $6,000 + $19,700

Total: $25,700 = $25,700

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Transaction 10• Transaction 10: Received interest on bank balance. Hamilton

Stationery Shop earned $50 on its Cash at Bank account balance.

• The transaction results in an increase to Cash Asset and a increase to Equity as a result of interest revenue being earned.

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

Assets = Liabilities

+ Owner’s Equity

Cash + Accounts Receivable + Inventory +Equipment Accounts Payable

Capital

Old bal. $13,900 + $400 + $2,400 + $9,000 = $6,000 + $19,700

Trans 10: + $50 + $50

New bal. $13,950 + $400 + $2,400 + $9,000 = $6,000 + $19,750

Total: $25,750 = $25,750

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Transaction Analysis• Well, you have done it!• The Hamilton Stationery Shop illustration using the

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

– Analyse transactions by identifying the accounts and their effects on the main financial elements: Assets, Liabilities, Equity, Revenue and Expenses.

– 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.

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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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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 - Expenses

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

Which can also be written as:

Assets + Expenses = Liabilities + Equity + Revenue