Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Lesson notes
Lesson 2: Economic Transactions and Accounting Equation
Learning objectives
This lesson begins with a discussion of the purpose of a business, including a discussion of
forms of organizations. Next, the nature of business operations is discussed. The four types of
businesses are discussed: service, merchandising, manufacturing, and financial services. It also
concludes with a discussion of the general forms of business ownership: sole proprietorships,
partnerships, and corporations.
Then the lesson carries on with a discussion of business activities and the events, resources,
and elements affecting business transactions. The focus of accounting equation (that is, A＝L＋
OE) is explained in detail. The Beauty Photo Store, a local case we create, is presented to illustrate
our points in this lesson
Teaching hours
Students major in accounting: 3 hours
Others:
3 hours
Teaching contents:
Opening Story
This lesson starts with an opening case of somewhat connection to the real life of students,
that is, the funding and spending at college. Suggested items relating to the accounting topics are:
Assets of a college student, for example, cash, CD player, computer, and the ways of funding these
assets: sponsored by parents, sponsored by relatives, borrowed from relatives and acquaintance.
We could deal with the above-mentioned financial issues from the following perspectives：
How do we fund our daily expenditures and possessions？How do we spend the “funds” which
we have sourced？What about the relationship between the “funds” which we have sourced and
our daily expenditures and possessions？
Enterprises
Students are asked to suggest examples of each type of business: service, merchandiser,
manufacturer, and financial services. Point out that many businesses are combinations of one or
more type.
Students are going to understand: Concept of Enterprise, Definition of “enterprise”,
Functions of an enterprise, Characteristics of an enterprise.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
There are three major forms of enterprise: Sole-proprietorship, Partnership, Corporations.
And there are four types of enterprise: Service organization provides services (does something for
you) rather than selling something; merchandising business buys goods, adds value to them, then
sells them to customers; manufacturer – makes the products it sells; financial services company
does not make tangible products and does not sell products made by other companies; deals in
services related to money
Resources in an Enterprise
Major resources in an enterprise:
1. Human resources: properties, plant and equipment, supplies, raw materials, finished
products or inventories
2. Financing (financial resources): For instance those in cash or bank deposits
3. Resources in material forms
Movements of Material Resources in an Enterprise
(An example-Beauty Photo Store)
Movements of Material Resources in an Enterprise
1) Movements in a manufacturing enterprise
cash/bank
deposit→raw
materials
products→fin→cash/bank deposit
2) Movements in a merchandising enterprise
cash/bank deposit→inventory→ cash/bank deposit
Activities of Enterprise
Three major phases of business activities:
1) Inception
2) Operating
3) Liquidation
Inception of Enterprise
1) Inception and investment of funds
* External funding
→work-in-process→finished
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
* State, legal persons, privates or foreign investors；
* Financing from banking institutions, other legal persons or privates
* Owners’ equity and liabilities
2) Forms of Investment
* Monetary (cash/bank deposits)
* Property, plants and equipment
* Raw materials and goods,etc.
3) Sources and changes of funds
* Increase of owners’equity or liabilities
* Increase of assets
Operating Activities
Operating activities and changes of asset
* Changes of assets in Beauty Photo Store
* Connections between Beauty Photo Store and Suppliers, clients, etc.
Liquidation of Enterprise
1) Liquidation of enterprise and payoff of funds
* Payment of taxes
* Distribution of profits
* Declaration of dividends
* Payoff of borrowings
2) Withdrawals and changes of funds
* Decrease of assets
* Decrease of liabilities or owners’ equity
Accounting Transactions
First of all, we define a business transaction as an event that affects the financial position of a
business and may be reliably recorded. Further, we will explore the relationship between the
Economic Activities and Accounting Elements. Accounting elements include assets, liabilities,
owner’s equity, revenues, expenses and profit (loss).
We should also know about the connection between the uses of funds and assets: the terms of
cash, equipment and others are mentioned; and the connection between the resources of funds and
equity: for instance, borrowings and equity of creditors － liabilities, investments and owner’s
equity. Uses and changes of funds are studied here too.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Beauty Photo Store case is reviewed here. from cash to equipment; using equipment to
produce photos; from photos to cash.
Circulation of funds: Uses of funds and assets, and payoff of funds for the Beauty Photo
Store: Cost of equipment, cost of supplies, human costs？(What are the operating purposes for
Beauty Photo Store？) Cash receptions and revenues by Beauty Photo Store, net increase of funds
and profit, difference between uses and payoff of cash？(Nature of profit?)
Accounting Transactions
Accounting transactions-Economic exchange between two different accounting entities:
Mutual exchange: A purchases an asset, paying cash or bearing the responsibility of paying cash in
future; B sells the asset, earning the rights of receiving or collecting cash; One-way transaction:
Investments or donations to another accounting entity
Accounting Events: Accounting events-internal transferring of resources among departments
of a same entity; allotments of raw materials for plants; Damages caused by earthquakes. External
versus internal events: Between different entities or within a same entity
Accounting Circumstances: Accounting circumstances-usually an outcome of collaboration
of multiple events. Circumstances and their impacts: Changes in prices, exchange rates; How to
determine these changes？E.g. uncollectability of receivables due to the liquidation of the debtor;
Unpredictability
Elaboration on Accounting Elements
Assets-Liabilities-Owner’s equity-Revenues-Expenses-Profits
Assets: Assets are economic resources owned by a business that are expected to be of benefit
in the future. Further Thoughts on Assets: Human resources as an asset？for example, value and
labor of Manager of Beauty Photo Store？Cameramen and shop assistants？Natural resources as
an asset?
Liabilities: Liabilities are creditor¡¯s claims to the assets. Liabilities are obligations to
outsiders
Owner’s Equity: Owner’s Equity is the owner’s claim to the assets. It is the amount of
assets that remains after subtracting the liabilities. Changes in Owner’s Equity; Investments by
owners and revenues, amounts earned by delivering goods or services to customers, increase
owner’s equity. Withdrawals of assets from the business by owners and expenses decrease owner’s
equity. Expenses occur when assets are used or liabilities increase as a result of earning revenues.
Revenue: Revenues (sales) are increases in owners' equity arising from increases in assets
received in exchange for the delivery of goods or services to customers. Revenues are increases in
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
economic resources, either through increases to assets or reductions to liabilities
Revenue Recognition: Revenue should be recognized in the financial statement when: 1) the
performance has been achieved; 2) there is reasonable assurance regarding the measurement and
collectability of the consideration
Expense: Expenses are decreases in owners' equity that arise because goods or services are
delivered to customers. Expenses are decreases in economic resources, either through outflows or
the using-up of assets or incurrence of liabilities from delivering or producing goods, rendering
services, or carrying out other activities that constitute the entity’s normal business.
Expense Recognition: Cost, expenditure, and expense; general recognition criteria.
Approaches to expense recognition are Cost, Expenditure, and Expense. When we agree to pay out
cash (or other assets) for goods or services received, we have incurred a cost. When we actually
pay the cash, we have expenditure. When the benefits of the cost have been used and we put that
cost (or a portion thereof) on the income statement, we have recognized an expense
General Recognition Criteria
Recognized items must meet the definition of a financial statement element and have a valid
measurement basis and amount. Financial statement elements are based on future economic
benefits or sacrifices; these must be probable for recognition to be appropriate.
Expenses are decreases in economic resources, either by way of outflows or reductions of
assets or incurrences of liabilities, resulting from an entity¡¯s ordinary revenue generating or
service delivery activities.
Asset or expense?
if the asset recognition criteria are met, an asset is recorded. If not, an
expense is recorded
Approaches to Expense Recognition
Definitional approach: expenses are created either through the reduction of an asset or the
increase in a liability
Matching approach: once revenues are determined in conformity with the revenue principle
for any reporting period, the expenses incurred in generating the revenue should be recognized in
that period
Profit/Loss
Income (profit or earnings) is the excess of revenues over expenses
Accounting Equation
Assets + Liabilities = Owners Equity
Net Assets = Owner’s Equity
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Every accounting transaction has an equal affect on both sides of the equation.
Purchase a $20,000 car for cash.
Increase asset car and decrease asset cash by $20,000. No net change to assets.
Purchase a $20,000 car on credit.
Increase asset car and increase liabilities by $20,000.
Dual Aspect of Accounting Equation
Assets = Liabilities + Owner’s equity.
LHS = RHS.
First view:
Resources = Obligations to creditors or claims on resources + Residual claim.
Second view:
Amounts invested in resources = how these amounts were financed.
Resources = financed by creditors + financed by owners.
An Illustration: Beauty Photo Store
Changes to the accounting equation of Beauty Photo Store (see the powerpoints)
Case for Discussion
Marks and Spencer
In 1882, a Russian refugee named Michael Marks came to the North East of England.
Needing work, he put a tray round his neck and started selling haberdashery in the villages around
Leeds. Two years later he borrowed ￡5 from his friend Isaac Dewhirst to buy stock, and was
able to open a stall in Leeds market.
Within ten years Marks’s success as a trader had enabled him to establish a chain of stalls in
markets throughout North East England. In 1894, Marks realized that his business was getting too
large for him to manage effectively on his own. He decided to form a partnership with Tom
Spencer – and Marks & Spencer was born.
The business continued to thrive and grow, so in 1903 Marks and Spencer registered their
partnership as a private limited company. This allowed more people to become involved with
managing the growing company and increase its finances by buying shares in the company. One
shareholder was Israel Sieff, who became chairman of the company in 1917. Sieff can be credited
with shaping the future of Marks & Spencer. By 1926, Marks & Spencer had opened 125 stores. In
order to continue its successful development the company finally registered as a public limited
company (plc) in order to obtain as much capital as possible to finance its continued growth.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
And the rest, as they say, is history.
Suggested Questions
1) How many people started the original business that eventually became Marks & Spencer?
2) Who owned the original business?
3) Who owns Marks & Spencer plc?
4) Why do you think Marks & Spencer became a public limited company?
5) Do you think the business would have developed in the way it has if it was still owned by
one person?