Lesson 2
Business Transactions and
Accounting Equation
Task Team of
FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Outline
• Enterprises
• Accounting Transactions, Accounting Events,
and Accounting Circumstances
• Economic Activities and Accounting Elements
• Accounting Equation
2
Opening Story
• Funding and Spending at College
– Assets of a college student
• Cash
• CD player
• Computer
– Funding these assets
• Sponsored by parents
• Sponsored by relatives
• Borrowed from relatives and acquaintance
3
Opening Story (continued）
• 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？
4
Enterprises
• Concept of Enterprise
– Definition of “enterprise”
– Functions of an enterprise
– Characteristics of an enterprise
5
Forms of Enterprise
• There are three major forms of enterprise:
– Sole-proprietorship
– Partnership
– Corporations
6
Sole proprietorships
• Single person owns the business
• Not separate from its owner in terms of
responsibility and liability
• The business is the owner and the owner is
the business
7
Partnership
• Owned by two or more people
• Similar to a sole proprietorship
• Not separate from the owners in terms of
responsibility and liability
8
Corporations
• Legally separate and financially separate from
the owners
• Ownership in a corporation is divided into
units called shares of capital stock
• Owners are called shareholders or
stockholders
• Corporations are separate legal entities
9
Characteristics of Enterprise
Characteristics
Business entity
Legal entity
Limited liability
Unlimited life
Business taxed
One owner allowed
Proprietorship
yes
no
no
no
no
yes
Partnership
yes
no
no
no
no
no
Corporation
yes
yes
yes
yes
yes
yes
10
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 – doesn’t make tangible
products and doesn’t sell products made by other
companies; deals in services related to money
11
Resources in an Enterprise
• Major resources：
– Human resources
– Properties,plant and equipment,supplies, raw
materials, finished products or inventories
– Financing
• In cash or bank deposits
• In material forms
12
Movements of Material Resources in
an Enterprise
• An example-Beauty Photo Store
13
Movements of Material Resources in
an Enterprise
– Movements in a manufacturing
enterprise
• cash/bank deposit→raw materials →work-inprocess→finished products→fin→cash/bank deposit
– Movements in a merchandising
enterprise
• cash/bank deposit→inventory→ cash/bank deposit
14
Activities of Enterprise
• Three major phases of business activities:
–Inception
–Operating
–Liquidation
15
Inception of Enterprise
– Inception and investment of funds
• External funding
– State, legal persons, privates or foreign investors；
– Financing from banking institutions, other legal
persons or privates
• Owners’equity and liabilities
Investment
of owners
Financing of
creditors
Total funds of a firm
16
Inception of Enterprise
– Forms of Investment
• Monetary(cash/bank deposits)
• Property, plants and equipment
• Raw materials and goods,etc.
– Sources and changes of funds
• Increase of owners’equity or liabilities
• Increase of assets
17
Operating Activities
• Operating activities and changes of asset
– Changes of assets in Beauty Photo Store
cash
2 cameras
lens
＋producing
equipment
＋
supplies
photos
cash
– Connections between Beauty Photo Store and
Suppliers, clients, etc.
18
Liquidation of Enterprise
• Liquidation of enterprise and payoff of funds
– Payment of taxes
– Distribution of profits
– Declaration of dividends
– Payoff of borrowings
• Withdrawals and changes of funds
– Decrease of assets
– Decrease of liabilities or owners’equity
19
Accounting Transactions
• A business transaction is an event that affects
the financial position of a business and may
be reliably recorded
20
Economic Activities and Accounting
Elements
• Accounting element：
–Uses of funds and assets
• cash
• equipment,etc.
–Resources of funds and equity
• Borrowings and equity of creditors-liabilities
• Investments and owners’equity
21
Uses of Funds
• Uses and changes of funds
– Beauty Photo Store
• From cash to equipment
• Using equipment to produce photos
• From photos to cash
22
Circulation of Funds
• Circulation of funds:
– Uses of funds
• Beauty Photo Store
– Cost of equipment
– Cost of supplies
– Human costs？
– Uses and payoff of funds
• What are the operating purposes for Beauty
Photo Store？
23
Payoff of Funds
– Payoff of Funds and Revenues
• Cash receptions and revenues by Beauty Photo
Store
– Net increase of funds and profit
• Difference between uses and payoff of cash？
• Nature of profit?
24
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
25
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
– Within a same entity
26
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
27
Accounting Elements
•
•
•
•
•
•
Assets
Liabilities
Owners’equity
Revenues
Expenses
Profits
28
Assets
• Assets are economic resources owned by
a business that are expected to be of
benefit in the future.
29
Further Thoughts on Assets
• Human resources as an asset？
– Value and labor of Manager of Beauty Photo Store？
– Cameramen and shop
assistants？
• Natural resources as an asset?
30
Liabilities
• Liabilities are creditor’s claims to the
assets. Liabilities are obligations to
outsiders
31
Owners’Equity
• Owner’s Equity is the owner’s claim to
the assets. It is the amount of assets that
remains after subtracting the liabilities.
32
Changes in Owners’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.
33
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 economic resources,
either through increases to assets or
reductions to liabilities
34
Revenue Recognition
• Revenue should be recognized in the financial
statement when:
– the performance has been achieved
– there is reasonable assurance regarding the
measurement and collectability of the
consideration
35
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
36
Expense Recognition
• Cost, expenditure, and expense
• General recognition criteria
• Approaches to expense recognition
37
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 an
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
38
General Recognition Criteria
• Recognized items must:
– meet the definition of a financial statement
element
– 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
39
General Recognition Criteria (cont)
• 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 [CICA 1000.38]
• Asset or expense? if the asset recognition
criteria are met, an asset is recorded. If not,
an expense is recorded
40
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
41
Profit / Loss
• Income (profit or earnings) is the excess of
revenues over expenses
42
Accounting Equation
• Assets – Liabilities = Owners Equity
• Net Assets = Owners’ Equity
• 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.
43
Dual Aspect of
Accounting Equation
• Assets = Liabilities + Owners’ 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.
44
Beauty Photo Store
-- An Illustration
• Changes to the accounting equation of Beauty
Photo Store：
Asset:130000
＋
Liability:30000
＝
Revenue:15000
＋
Expense:9000
＝
Profit:6000
Assets
130000＋15000－9000
＋
Liabilities30000
＝
Owners’ equity
100000＋6000
Equity:100000
45
Summary
• Economic resources in the enterprisehuman,financial and material resources
• Economic transactions derive from the operating
activities of an enterprise
• Accounting elements are basic components of
economic transactions
• Accounting elements comprise of assets,liabilities,
owners’equity, revenues, expenses and profit
• Economic transactions are viewed in the forms of
increase or decrease in accounting elements
• Accounting equation：A＝L＋OE
46
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.
47
Case for Discussion (cont)
• 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.
• And the rest, as they say,
is history.
48
Suggested Questions
• How many people started the original business that
eventually became Marks & Spencer?
• Who owned the original business?
• Who owns Marks & Spencer plc?
• Why do you think Marks & Spencer became a public
limited company?
• Do you think the business would have developed in
the way it has if it was still owned by one person?
49
The End of Lesson 2