bookkeeping – Page 4 – Accounting Crash Course

The Balance Sheet

As discussed in my earlier posts, the balance sheet shows the financial position of an entity. In addition to the example introduced earlier whereby the owner contributed $10,000 cash at bank as capital (please refer to my post titled Debits and Credits), there are many more examples of transactions that have an impact on the balance sheet, i.e. they would change the items and figures reflected in the balance sheet. Some of the examples are as follows:-

1. Purchase of asset using cash at bank (by way of issuing cheque)

Using the example of ABC Limited in which the owner have contributed $10,000 cash at bank as capital, assume the owner decided to use part of the money to purchase an asset e.g. a computer desk costing $500, the double entry would be as follow:-

Dr. Computer desk $500

Cr. Cash at bank $500

After the transaction has been effected, the balance sheet of ABC Co. Limited would show:-

ABC Co. Limited
Balance Sheet as at 31 December 2006
	$
Assets
Computer desk	500
Cash at bank	9,500
Liabilities	–
TOTAL	10,000
Owners’ Equity
Paid-up share capital	10,000
TOTAL	10,000

As you can see here, $500 cash at bank used to purchase the computer desk is now recorded as a new asset item called “Computer desk” and as a result, the money left in the bank has reduced from $10,000 to $9,500. Take note that this transaction has NO EFFECT on the Owners’ Equity nor its Liabilities. In other words this is a transaction that affects the assets of ABC Co. Limited.

2. Purchase of asset under credit

Refer to the example of ABC Co. Ltd again, assume this time instead of purchasing the $500 computer desk using the money in the bank, the Owner of ABC Co. Ltd purchased it under credit, i.e. ABC Co. Ltd owes the creditor (Mr X, the computer desk vendor) $500 until it is paid. The double entry would be as follow:-

Dr. Computer desk $500

Cr. Creditor-Mr X $500

After the transaction is effected, the balance sheet would show:-

ABC Co. Limited
Balance Sheet as at 31 December 2006
	$
Assets
Computer desk	500
Cash at bank	10,000
	10,500
Liabilities
Creditor-Mr X	(500)
TOTAL (Assets – Liabilities)	10,000
Owners’ Equity
Paid-up share capital	10,000
TOTAL	10,000

Same as Example 1, a new asset, “Computer desk” is created. In addition, a new liability item, “Creditor-Mr X” is also created. Again this is a transaction that has NO EFFECT on Owners’ Equity. However, it is a transaction that has an effect on Asset (Computer desk) and Liability (Creditor-Mr X).

Please take note that not all transactions affect only the Balance Sheet, there are transactions that have their effect on the Income Statement or Profit and Loss Account as well which I will discuss in later topics.

Debits and Credits

These two words are typical to the world of accounting and they relate to the Accounting Equation: –

Assets = Liabilities + Owners’ Equity

Under what we called double entry system in accounting, each transaction must be recorded TWO times. For example, when you as an owner of an entity you contribute capital to the business by opening a bank account lets say $10,000, the following entry is made: –

Dr. Cash at bank $10,000 (Asset)

Cr. Paid-up share capital $10,000 (Owners’ Equity)

Note: Dr. represents “debit” and Cr. represents “credit”

Points to note: –

1. All assets item when recorded initially, you must follow the convention of “debiting” the account relating to that particular asset.

2. All liabilities item and Owners’ Equity item on the other hand you must “credit” the relevant accounts relating to that item when you first recognise them.

Refer to the above example, if right after you have contributed the capital to the business and there are no further transactions till the end of the financial year (this is the last day of the period that you wish to set as the financial period for your business entity, 12 months is the full financial period in a year) say 31 December 2006, the Balance Sheet of your business as at 31 December 2006 looks like this: –

ABC Co. Limited
Balance Sheet as at 31 December 2006
	$
Assets
Cash at bank	10,000
TOTAL	10,000

Liabilities	–

Owners’ Equity
Paid-up share capital	10,000
TOTAL	10,000

The above balance sheet shows the financial position of ABC Co. Limited as at 31 December 2006 i.e. on this date, the entity has $10,000 worth of asset, cash at bank to be specific, which is financed or represented by the $10,000 of paid-up share capital contributed by its owner. Can you see that with the figures included, the Accounting Equation has now become meaningful? Of course in this example, the entity has no liabilities.

The Accounting Equation

You can find a lot of materials on-line about what accounting is about and you will not miss them mentioning The Accounting Equation: –

ASSETS = LIABILITIES + OWNERS’ EQUITY

Assets are simply those things that are valuable to an entity and they include items such as the equipment bought and used in business, the trade receivables, cash kept at banks, inventories & etc. Generally, the entity must have some form of control over these items and enjoy the benefits that these items would bring to the entity. It is easier to understand the meaning of benefits to the owner if you could picture that by using the assets in your business, they would help generate the sales/revenue which is important to a profit orientated entity. (Mmm… leave your thoughts on profit to later discussions – How well an entity manage/use the assets and also the liabilities will have an outcome on the profit to be generated by the entity)

An entity does not own an asset out of nothing (Remember the old phrase – there is no free lunch in this world?). Yes, either you pay for it using your own money (i.e. Owners’ Equity) OR if you don’t have any money, borrow (i.e. Liabilities). Yes, that is the meaning of the accounting equation – All the assets of an entity must equal to the sum of all the liabilities plus the owners’ contributions to the business! Simple right? If you stick to this formula in recording EACH and EVERY transaction of an entity over a period of time, you would get a set of accounts in which the outcome of is what we call a BALANCE SHEET (Some refer to this as a Statement of Assets and Liabilities) and INCOME STATEMENT (Some refer to this as a Profit and Loss Account), which we will discuss in later topics.