ACCT1005 W4 LE4

An account is a record in a general ledger of an accounting system that is used to sort, store and summarise financial transactions of a business. For example, the cash in bank account is used to record all transactions that affect the bank account of the business. The account will then be balanced at the end of each reporting period to determine the cash in bank balance. This is essentially a summary of the result of business transactions on the bank account.

 

A chart of accounts is a list of all the accounts a business has included in its accounting information system. Accounts in the accounting system are categorised as an asset, liability, equity, income or expense account. Each category has multiple accounts within representing a unique function of the business finances. For example, the account used to represent the business bank account, usually called cash bank, is classified as an asset account.

 

Businesses use the chart of accounts to organise all intricate details of their business finances into an accessible format. It's the first set in setting up a business's account system. The chart of accounts clearly separates earnings, also called income, expenditures, assets and liabilities, to give an accurate overview of the business, financial position and performance. The chart of accounts organises finances into numbered account types. Most businesses follow a consistent and commonly accepted account numbering system. Numbers starting with 1 (100-199) are for assets. Numbers starting with 2 (200-299) are for liabilities. Numbers starting with 3 (300-399) for equity. Numbers starting with 4 (400-499) for income/revenue. Numbers starting with 5 (500-599) are for expenses.

 

Assets are the resources owned or controlled by a business that will provide a current or future economic benefit. The economic benefit might be from selling the asset, such as the sale of inventory in a retail business, or from using the asset in the business to produce income and increase wealth, such as a computer software, or motor vehicle or business premises. Assets can also be classified as either current or non current, depending on the length of time the asset is likely to provide economic benefit.

 

Current assets are those assets that are going to be converted into cash within the next 12 months.

  • Cash: Most liquid.

  • Accounts receivable: Cash that is due in from customers who have already received goods or services that they haven't paid yet.

  • Inventory: Goods that have been held with the intention to resell for a profit.

  • Prepayments: Expenses that have been paid in advance and not yet used up. They won't convert to cash but they will save the business from expending more cash.

 

Non current assets are those that will provide a future economic benefit for multiple periods or for longer than 12 months.

  • Equipment

  • Motor vehicles

  • Office furniture

  • Office equipment: Printers, computers

  • Property

Most non current assets are gradually depreciated over their life to recognise the use of the non current asset to generate income during the accounting period. This is called a depreciation expense.

 

Assets can further be classified into tangible and intangible assets.

  • Tangible: Physical, can touch and feel them, e.g. motor vehicle, building, machinery

  • Intangible: e.g. copyrights, patents, goodwill, cryptocurrencies

 

A liability is an obligation or a debt owed by the business to external parties, and it must be repaid in the future. The obligation may require a commitment to repay a debt at a future time, or to provide goods or services. Liabilities are divided into both current and non current.

 

Current liabilities are liabilities that will be paid in the next 12 months.

  • Accounts payable: The amount that the business owes to its trade suppliers for goods and services that they've received but have not yet paid for.

  • Short term loan

  • Unearned revenue is a deposit from a customer that has not yet received their goods or services, so the obligation is of the business to then provide those goods or services.

 

Non current liabilities are liabilities that extend beyond the 12 month period or into the next accounting reporting period.

  • Mortgage

  • Long term loan

 

The liabilities account that are used in a chart of accounts of a business reflect the different liabilities that that business may have.

 

An equity is the net value of the business. It is the residual value of assets, after all liabilities have been settled or paid for. Equity accounts are used to record transactions between the business and the business owners. Therefore, different business structures which have different ownership structures will use different equity accounts.

 

So if we talk about sole traders and partnerships, both these forms of business have equity called owner's equity. This is because there is no separate legal entity separate from the owners of the business under these structures. Owners in sole trader or partnership businesses contribute capital to the business, so capital is an account within owner's equity. Capital is the assets that have been transferred to the business by the owners. Could be cash, assets, value of which are represented here. When sole traders or partners withdraw money from the business for personal use, it's called drawings. In a partnership, each partner will have a separate capital and separate drawings account to record the contributions and withdrawals of each partner separately. Owner's equity under both structures is increased by any profit if the business. Profit would be the result of the income of the business. This is when the expenses of the business are less than the income of the business over the accounting reporting period.

 

Equity under a company is called shareholder's equity because the shareholders are the owners of the business. Shareholder's equity is made up of share capital, which is the money received by the company from shareholders when the company issues shares for sale. When the business makes a profit, this is kept in a separate account called retained earnings. When the company shares its profit with the shareholders, it issues a dividend which are paid out of retained earnings. The company may also choose to keep some profit to fund business expansion and growth. Any profit that is not distributed remains in the retained earnings accounts.

 

Income (revenue) are the receipts of earnings from sale of goods or services provided. The type of income accounts used will depend on the nature of the business.

  • Income generated from retailers or manufacturers, are referred to as sales or sales revenue. They're actually selling physical goods.

  • Professional businesses such as accounting and legal services refer to their income as service fees or service income, because they generally provide more of a service than goods that are tangible.

  • Some businesses will generate income from both sales and services, e.g. trades where they have a combination of skilled labour and the provision of materials.

 

Expenses are costs incurred in the process of generating income. They require an outlay of resources which will provide a benefit to the business in the short term. Examples of expenses include rent on business premises, employee wages, office supplies such as pens, paper and ink cartridges, and cost of goods sold and utilities. The difference between an asset and expense is that assets provide a future economic benefit, while expenses are consumed almost immediately, or do not provide a benefit beyond the current accounting period, usually one year. Some assets can become an expense when the economic benefits of the asset are consumed or depleted during business activities. For example, when inventory, which is a current asset, is sold, the cost of the inventory is then recorded as an expense against the cost of sales or cost of goods sold. Prepaid expenses are expenses that have been paid in advance, but they become expensed after the economic benefit is used up. For example, prepaid rent, paid for six months in advance, and at the end of that six months, it will become used up and become an expense. Another example is the running costs on a motor vehicle. In the current accounting period, motor vehicle expenses would include fuel, service cost, registration and insurance. These expenses have been consumed to earn current income and don't provide a future benefit. The motor vehicle itself may be  used over several years and provides a future benefit to the business, and is therefore considered an asset. Like a motor vehicle, most assets are gradually depreciated over their useful life to recognise the use of the asset to generate income during the accounting period. This recognition results in a depreciation expense.

 

To recap the difference between assets and expenses, they both provide an economic benefit, the differences in the timing of the benefit. An asset is an economic resource that will be consumed at a future point. An expense is consumed almost immediately and doesn't provide an economic benefit in the future. Some assets can become an expense when the economic benefits of the asset are consumed or depleted during business activities, such as inventory becoming the cost of goods sold or prepaid expenses being consumed over the time. We also depreciate our non current assets to recognise that they have a part in earning the income generated for that period.

 

The effect of a business transaction is best analysed and explained using the accounting equation. The basic accounting equation was assets = liabilities + equity. This is accounting in a nutshell and the basis of how accounting works, from how to analyse and record transactions, to how to report a summary of all transactions on the financial statements. This short equation explains that assets are the economic resources controlled by the entity, and tells of the relationship of these assets to how they were financed, either by incurring a liability, such as a bank loan by capital provided by business owners. Assets are economic resources such as cash and equipment. Liabilities are amounts owed to third parties, such as banks or suppliers. And equity is the value of assets remaining after liabilities are paid. We can use an expanded accounting equation to explain how equity changes over time, and how business transactions lead to those changes. While the assets and liabilities components in the expanded equation don't change, the equity can be expanded to capital contributed by owners that is increased by business income and is reduced by business expenses and withdrawals of capital by the owners. Therefore, the expanded accounting equation is assets + liabilities + equity ( + income - expenses).

 

The double entry accounting system is based on the concept of duality, which means that each transaction has a dual effect on the account equation. Each transaction must affect at least two accounts.

  • The first effect is the cash movement effect. There will be a movement of cash now or in the future as a result of a transaction. Money will be paid or received. If the money moves at the time of the transaction, it will affect the cash account. If money is going to be paid or received in the future, it will affect accounts receivable asset account or a liability account such as accounts payable.

  • The second effect of the transaction is called the category of transaction effect, which reflects the purpose of the transaction, why the transaction occurred. If it was to purchase an asset such as equipment, it will affect an asset account. If it was to make a sale of goods, it will affect an income account.

In the analysis of each transaction, there must be a cash effect and a purpose effect on the accounts of the business, as there is at least two accounts affected. The accounting equation remains in balance. e.g.

  • The purchase of a delivery truck financed by bank loan. The cash movement effect is the loan payable in the future, so the liability account of line payable is affected. The purpose of the transaction, or the category of transaction effect, is the purchase of an asset, being the delivery truck, to support the operations of the business. Therefore, this transaction will result in an increase in assets by the value of the truck and an increase in liabilities by the value of the loan. In this simple example, these values are equal, and only these two accounts are affected. In a more complex example, it may involve a part payment of cash and a part of a loan.

  • An owner commences business by contributing $20000 capital to the business bank account. The cash movement effect will be an increasing cash asset account of $20000. The purpose effect will be an investment by the owner of capital, increasing equity by $20000.

  • A business pays rent of business premises of $300. The cash movement effect is a decrease in cash asset account of $300, and the purpose of the transaction is to secure use of the business premises by way of a rental agreement, resulting in rent expense of $300.

  • A business purchase of office supplies on credit $80. The cash movement is the obligation to pay $80 in the future because the purchase was on credit. This will increase accounts payable liability account. The purpose is to obtain office supplies such as paper or packaging, which increases an expense account by $80, taking the accounting equation in balance.

  • A customer is invoiced for services provided $200. The cash effect is the future receipt of cash from the customer. So it's an increase in the asset account of accounts receivable, and the purpose effect is the generation of business income, so an increase in service fees income account.

  • Where a transaction has led to a liability in the past, another transaction is created when the liability is paid. For example, paying a bill previously recorded as accounts payable for $90. When the accounts payable is paid, the cash effect is movement of cash to the supplier, reducing the cash asset account by $90. The purpose effect of the transaction is to pay the past debt which is a reduction in the accounts payable liability account as $90.

  • An owner withdraws $500 for personal expenses. The cash effect will be a reduction in the business asset account of cash by $500 and a reduction in the equity by increasing the drawings account. Remember owner's equity = capital - drawings. So when drawings is increased, owner's equity is decreased.