[R-IB1240-2] DOUBLE-ENTRY BOOKKEEPING
Reading: 7.1-7.2, 7.4, 8.2, 9.1-9.4, 9.6
THE ACCOUNTING EQUATION AND ITS COMPONENTS
The Statement of Financial Position as an Accounting Equation
● An accounting entity may be viewed as a set of assets and liabilities. The most familiar form this
takes is the statement of financial position. An equation would appear as follows
Proprietors’ ownership interest in the business = Net resources of the business
● The ownership interest or claims are called owners’ equity or owners’ capital. The net resources
are analysed into assets and liabilities
● The use of the word ‘net’ to describe the resources possessed by the business recognises that
there are some amounts set against or to be deducted from the assets; these are called liabilities
● Given that liabilities can be regarded as being negative in relation to assets, the accounting
equation can now be stated as: Assets - Liabilities = Owners’ Capital
○ This equation is based on what is sometimes referred to as the duality or ‘dual aspect
concept’
○ This concept purports that every transaction has two aspects: one represented by an asset
and the other a liability or two changes in either the assets or the liabilities
■ Example: The purchase of an asset on credit will increase the assets and the
liabilities of the by the same amount. The purchase of a vehicle for cash will
increase the value of the vehicle asset but decrease the amount of cash.
● The accounting equation is a valuable basis for the process of accounting. It sets out the financial
position of the owners at any point in time or in practice - after a period
The Accounting Equation and Profit Reporting
● An absence for a figure for capital will not prevent the statement of financial position from being
drawn up
● Given that capital is the only missing figure in the accounting equation, the accounting rule will
apply - the debits will equal the credits
○ As the assets and liabilities are known then the difference will be the capital
● Capital is the balancing item. The capital figure at the end of the year is different to that at the
beginning, an analysis and explanation of that change is needed to provide a more complete
picture
● At the start the company has an opening balance (£20,000) and a closing capital balance
(£32,000) this is an increase of £12,000
○ One possible explanation is that the owner paid some more money into the business and
also increase capital generated by the business itself - profit
○ Example of how profit is able to generate increases in capital. A trader starts a small
venture with £30 in cash, equivalent to £30 capital. She uses the money to buy a bath
which she sells for £40 and has increase capital by £10 (profit)
● To provide a more useful definition of profit as increase capital, accounting has made use of
explanations given by the economic Hicks (1946) who defines profit as maximum amount that
could be withdrawn in a period from the business while leaving the capital intact
, ● Measuring profit in relation to capital that is kept intact is commonly described as a capital
maintenance approach, which forms one of the major pillars of profit measurement theory
Revenue Expenditure Versus Capital Expenditure
● Capital expenditure relates to items that appear in the statement of financial position
○ Capital expenditure is not just the purchase cost of a non-current asset. Any expenditure
on an asset that increases its revenue generating potential beyond what it was originally
capable of is considered to be capital
● Revenue expenditure encapsulates items that appear in the statement of profit or loss
(comprehensive income) - value of item consumed (e.g. telephone bill, electricity, rent)
● Allocation expenditure to the incorrect type of account has a major impact on an entity’s reported
performance and financial position
○ Revenue expenditure reduces profitability, whereas capital expenditure ends up in the
statement of financial position with a portion of the expenditure being allocated to the
statement of profit or loss in line with the use of the asset
BASIC DOCUMENTATION AND BOOKS OF ACCOUNT
Basic Documentation for Cash and Credit Transactions
● In accounting, a cash transaction is one where goods or services are paid for in cash or by cheque
when they are received or delivered
● A credit transaction is one where payment is made or received some time after delivery (normally
in one installment)
● Credit transactions often involve trade discounts.
○ This is a discount given by one trader to another. It is usually expressed as a percentage
reduction of the recommended retail price of the goods, and is deducted in arriving at the
amount the buyer is charged for the goods
Reading: 7.1-7.2, 7.4, 8.2, 9.1-9.4, 9.6
THE ACCOUNTING EQUATION AND ITS COMPONENTS
The Statement of Financial Position as an Accounting Equation
● An accounting entity may be viewed as a set of assets and liabilities. The most familiar form this
takes is the statement of financial position. An equation would appear as follows
Proprietors’ ownership interest in the business = Net resources of the business
● The ownership interest or claims are called owners’ equity or owners’ capital. The net resources
are analysed into assets and liabilities
● The use of the word ‘net’ to describe the resources possessed by the business recognises that
there are some amounts set against or to be deducted from the assets; these are called liabilities
● Given that liabilities can be regarded as being negative in relation to assets, the accounting
equation can now be stated as: Assets - Liabilities = Owners’ Capital
○ This equation is based on what is sometimes referred to as the duality or ‘dual aspect
concept’
○ This concept purports that every transaction has two aspects: one represented by an asset
and the other a liability or two changes in either the assets or the liabilities
■ Example: The purchase of an asset on credit will increase the assets and the
liabilities of the by the same amount. The purchase of a vehicle for cash will
increase the value of the vehicle asset but decrease the amount of cash.
● The accounting equation is a valuable basis for the process of accounting. It sets out the financial
position of the owners at any point in time or in practice - after a period
The Accounting Equation and Profit Reporting
● An absence for a figure for capital will not prevent the statement of financial position from being
drawn up
● Given that capital is the only missing figure in the accounting equation, the accounting rule will
apply - the debits will equal the credits
○ As the assets and liabilities are known then the difference will be the capital
● Capital is the balancing item. The capital figure at the end of the year is different to that at the
beginning, an analysis and explanation of that change is needed to provide a more complete
picture
● At the start the company has an opening balance (£20,000) and a closing capital balance
(£32,000) this is an increase of £12,000
○ One possible explanation is that the owner paid some more money into the business and
also increase capital generated by the business itself - profit
○ Example of how profit is able to generate increases in capital. A trader starts a small
venture with £30 in cash, equivalent to £30 capital. She uses the money to buy a bath
which she sells for £40 and has increase capital by £10 (profit)
● To provide a more useful definition of profit as increase capital, accounting has made use of
explanations given by the economic Hicks (1946) who defines profit as maximum amount that
could be withdrawn in a period from the business while leaving the capital intact
, ● Measuring profit in relation to capital that is kept intact is commonly described as a capital
maintenance approach, which forms one of the major pillars of profit measurement theory
Revenue Expenditure Versus Capital Expenditure
● Capital expenditure relates to items that appear in the statement of financial position
○ Capital expenditure is not just the purchase cost of a non-current asset. Any expenditure
on an asset that increases its revenue generating potential beyond what it was originally
capable of is considered to be capital
● Revenue expenditure encapsulates items that appear in the statement of profit or loss
(comprehensive income) - value of item consumed (e.g. telephone bill, electricity, rent)
● Allocation expenditure to the incorrect type of account has a major impact on an entity’s reported
performance and financial position
○ Revenue expenditure reduces profitability, whereas capital expenditure ends up in the
statement of financial position with a portion of the expenditure being allocated to the
statement of profit or loss in line with the use of the asset
BASIC DOCUMENTATION AND BOOKS OF ACCOUNT
Basic Documentation for Cash and Credit Transactions
● In accounting, a cash transaction is one where goods or services are paid for in cash or by cheque
when they are received or delivered
● A credit transaction is one where payment is made or received some time after delivery (normally
in one installment)
● Credit transactions often involve trade discounts.
○ This is a discount given by one trader to another. It is usually expressed as a percentage
reduction of the recommended retail price of the goods, and is deducted in arriving at the
amount the buyer is charged for the goods
