# 2 The Equation Learning Objectives

## Presentation on theme: "2 The Equation Learning Objectives"— Presentation transcript:

2 The Equation Learning Objectives
Describe and use the fundamental accounting equation. Identify five basic classes of accounts Explain five essential accounting concepts Analysis: Percentage of sales (common size income statements) Unit 2

Objective 2.1: The accounting equation
The following slides use Jack & Jill Enterprises to demonstrate the fundamental accounting equation O2.1

Jack and Jill Enterprises
Hey Jill! Lets fetch water and make some money You fetch I’ll supervise O2.1

Jack and Jill Enterprises
We receive \$1 for each pail of water we fetch And we pay \$1 to replace each shoe we wear out O2.1

First, we can list all of J & J’s assets in a blue box.
Cash 3 Pails 2 Total 5 O2.1

Assets Liabilities Equity
Cash 3 Mom payable 2 The red box has two parts, creditors and owners. Pails 2 Next, list all the claims against the assets in a red box. Equity Jack & Jill, Capital 3 Total 5 Total 5 O2.1

Assets Liabilities Equity
Cash 3 Mom payable 2 Pails 2 The most important thing to remember is the total in the blue box must always equal the total in the red box. A = L + E Equity Jack & Jill, Capital 3 Total 5 Total 5 O2.1

This is the BALANCE SHEET
Assets Liabilities Equity

Now lets see how this system works for J & J Enterprises
Now lets see how this system works for J & J Enterprises. (Remember, Assets must always equal Liabilities Plus Owner’s Equity. O2.1

Jack and Jill Enterprises
Assets Liabilities Mom payable 2 3 4 Cash 6 7 5 8 7 Pails 2 Fetch 1 Pail Fetch 2 Pails Fetch 1 Pail Buy 2 Shoes Fetch 3 Pails Buy 1 Shoe Equity 4 3 8 7 6 5 7 J&J, Capital 9 5 10 6 8 5 Total assets 7 9 Total Liab. + Equity 8 9 7 6 10 9 O2.1

The system stayed in balance
We increased Equity with each sale We decreased Equity for each expense. The system stayed in balance Assets Liabilities Equity O2.1

Answer: With this simplified system, you would have have to memorize
So what are the total sales earned by Jack and Jill so far? Answer: With this simplified system, you would have have to memorize the total sales. Sales ? O2.1

Jack and Jill Enterprises I wish I could remember what our sales were.
Assets Liabilities Mom payable 2 3 I wish I could remember what our sales were. 4 Cash 6 7 5 8 7 Pails 2 Equity 4 3 8 6 7 7 5 J&J, Capital 5 10 9 8 6 5 Total assets 7 9 Total Liab. + Equity 7 8 9 10 9 6 O2.1

We need a better method to
keep track of sales and expenses for each time period BALANCE SHEET INCOME STATEMENT Solution: The Income Statement O2.1

To keep track of sales and expenses
for any given period. Income Statement A separate “temporary” list of Sales and Expenses BALANCE SHEET INCOME STATEMENT O2.1

The Sales and Expenses are collected on the Income Statement
BALANCE SHEET INCOME STATEMENT Sales Assets Liabilities Equity Expenses O2.1

The resulting Profit or Loss
is calculated BALANCE SHEET INCOME STATEMENT Sales Assets Liabilities Equity Expenses Profit Loss O2.1

At the end of the time period The Profit or Loss is moved to Equity
BALANCE SHEET INCOME STATEMENT Sales Assets Liabilities Equity Expenses Let’s try it Profit Loss O2.1

Jack and Jill Enterprises
Balance Sheet Income Statement Assets Liabilities + Equity Cash Pails Total assets Mom payable J&J, Capital Total Liab & Equity Revenue 3 6 8 4 2 1 7 7 5 3 7 4 2 Shoe Expense 3 2 3 5 9 10 7 9 5 8 6 Fetch 1 Pail Fetch 2 Pails Fetch 1 Pail Buy 2 Shoes 1 3 2 4 4 5 Fetch 3 Pails Buy 1 Shoe OR O2.1

This is a big improvement
This is a big improvement. The Income Statement allows us to tell at a glance what the sales and expense totals are. The Income Statement is used to collect sales and expenses for a given time period -for example a month or a year. O2.1

Jack and Jill Enterprises
Balance Sheet Income Statement Assets Liabilities + Equity Cash Pails Total assets Mom payable J&J, Capital Total Liab & Equity Revenue 4 8 6 3 2 1 7 5 7 3 4 7 2 Shoe Expense 3 2 3 5 9 10 7 9 6 5 8 The systems stays balanced –you must consider the change in J&J Capital that is being recorded in the Income Statement 3 1 4 5 4 2 OR O2.1

Assets = Liabilities + Equity + Revenues - Expenses
Following are exercises using the fundamental accounting equation Assets = Liabilities + Equity + Revenues - Expenses O2.1

Assets Liabilities Equity
What is Total Equity? 78 Total Liabilities Equity ? Total Equity 72 Total Assets 150 Total Liab & Equity 150 O2.1

What are Total Liabilities?
Assets Liabilities What are Total Liabilities? ? 1092 Total Liabilities Equity Total Equity 658 Total Assets 1750 Total Liab & Equity 1750 O2.1

Assets Liabilities Equity
What are Total Assets? Total Liabilities 6,420 Equity Total Equity 3,430 ? Total Assets 9,850 Total Liab & Equity 9,850 O2.1

What is the total Owner, Capital?
Balance Sheet Income Statement Assets Liabilities + Equity Total assets Total Liabilities Owner, Capital (Beginning) Total Liab & Equity Revenue 1 3 4 870 Expenses 2 405 ? 1,275 10 7 9 8 5 6 1,275 3 1 4 2 5 What is the total Owner, Capital? OR O2.1

What is the total Owner, Capital? (consider the Income Statement also)
Balance Sheet Income Statement Assets Liabilities + Equity Total assets Total Liabilities Owner, Capital (Beginning) Total Liab & Equity Revenue 1 3 100 4 870 Expenses 25 2 405 ? 1,350 10 7 9 5 8 6 Beg. Owner Capital 405 plus Revenue 100 minus Expenses 25 = 480 Ending Owner, Capital What is the total Owner, Capital? (consider the Income Statement also) 75 3 1 4 2 5 OR O2.1

Objective 2.2: Account Classification
The following slides offer an expanded Balance Sheet and Income Statement to help understand the 5 classes of accounts O2.2

There are 5 basic classes of accounts
Balance Sheet Income Statement Assets Liabilities + Equity 4. Revenue Cash Accounts Receivable Supplies Inventory Land Buildings Equipment Copyrights Accounts Payable Wages Payable Taxes Payable Unearned Revenue Notes Payable Owner’s, Capital 2. Liabilities Revenue 1. Assets Cost of Goods Sold Wages Expense Taxes Expense Rent Expense Utilities Expense Interest expense 5. Expenses 3. Equity There are 5 basic classes of accounts Profit OR Loss O2.2

There are a number of words used in account descriptions that help us identify the classification.
Note the words on the following slide and the classification they indicate O2.2

Remember where these words belong!
Earned Income Payable Cash Revenue Sales Receivable Unearned Prepaids Expense Capital Equipment Withdrawals O2.2

Where does this account belong?
Accounts Receivable Accounts Receivable O2.2

Where does this account belong?
Prepaid Insurance Prepaid Insurance O2.2

Where does this account belong?
Accounts Payable Accounts Payable O2.2

Where does this account belong?
Sales Sales O2.2

Where does this account belong?
Rent expense Rent expense O2.2

Where does this account belong?
Taxes payable Taxes payable O2.2

Where does this account belong?
J. Black, Capital J. Black, Capital O2.2

Where does this account belong?
Interest Income Interest Income O2.2

Where does this account belong?
Interest expense Interest expense O2.2

Where does this account belong?
Equipment Equipment O2.2

Where does this account belong?
Salary expense Salary expense O2.2

Where does this account belong?
Fee Income Fee Income O2.2

Where does this account belong?
J. Black, Drawing J. Black, Drawing O2.2

Where does this account belong?
Unearned Revenue Unearned Revenue O2.2

Where does this account belong?
Cost of Goods Sold Cost of Goods Sold O2.2

Where does this account belong?
Cash Cash O2.2

Where does this account belong?
Dividend Revenue Dividend Revenue O2.2

Objective 2.3: Concepts The following slides present 6 important concepts that guide many accounting practices and decisions. O2.3

(Monetary Unity) Concept Revenue Recognition Concept
Concepts Objectivity Concept Unit of Measure (Monetary Unity) Concept Matching Concept Cost Concept Periodicity Concept Revenue Recognition Concept O2.3

(Monetary Unity) Concept
Simply put, we must express accounts in monetary units such as dollars. Unit of Measure (Monetary Unity) Concept The monetary unit used is specific to the country in which business activity is conducted. \$ £ ¥ DM O2.3

Information collected in
Accounting information should be separated into regular time periods such as months, quarters and years. Periodicity Concept Information collected in time periods allows comparisons that help us track financial progress. O2.3

For any accounting time period, all expenses that were incurred to earn revenues for that period must be matched (recorded as an expense) in that same time period. Matching Concept This concept is one that guides a great deal of accounting activity in the production of accrual financial statements O2.3

Historical cost is used to record values in the accounts (in most cases) rather than current market values or replacement costs Cost Concept This concept is part of the conservative approach to financial reporting that is required by FASB O2.3

When recording values where historical cost is not relevant, objective information is required rather than (subjective) values based on opinion or educated guesses. Objectivity Concept Objective information is provided by reliable, unbiased third parties, generally from market data O2.3

Revenue Recognition Concept
Revenue should be recorded when it is earned and receivable. Record revenue when the seller has completed everything necessary to have the right to receive payment O2.3

What concept is involved?
Tom buys 12 new kayaks to add to his inventory paying \$425 each from a dealer going out of business. Tom buys the same kayak from the manufacturer for \$675. Cost Concept What value should be recorded in the accounts for this purchase? \$425 each O2.3

What concept is involved?
Thao wants to invest a 2 year old delivery van owned personally into her florist business. She saw two identical vans for sale at \$36,000. She paid \$47,000 for the van two years ago. Current published values for the van indicate a value of \$31,000. Objectivity Concept What value should be recorded in the accounts for this investment? \$31,000 O2.3

What concept is involved?
It is important to express accounting information in a common denominator of units that is simple, reliable, universally available and understandable. Unit of Measure (Monetary Unity) Concept \$ £ ¥ DM O2.3

What concept is involved?
There would be limited value in accounting information that continuously accumulated sales and expenses month after month, year after year without interruption. Periodicity Concept O2.3

What concept is involved?
Tom sells a kayak for \$950 and records the revenue. What else should Tom record as a result of this sale? Matching Concept Tom should record the expense (Cost of Goods Sold) for the cost incurred to acquire this inventory item. O2.3

What concept is involved?
Mark’s Hydraulic Repair receives a repair job from a credit customer on May 15, completes the job on May 18 and bills the customer. The customer picks up the repair on May 22. When can Mark’s record the revenue? Revenue Recognition Concept Mark’s can record the revenue on the day the work was completed, May 18 O2.3

Objective 2.4: Common size income statement
Useful information can be obtained by expressing income statement items in terms of their percentage of sales. O2.4

A standard common size percentage calculated is net profit as a percentage of sales.
This allows comparison from one period to the next 46,400/268,000 = 17% O2.4

End of Unit 2