BUSINESS: 415 TOPIC TWO RECORDING BUSINESS TRANSACTIONS

BUSINESS: 415 TOPIC TWO RECORDING BUSINESS TRANSACTIONS 2.1 Introduction A business can be set up in two ways- i) Owner supplying all the resources ii) Owner supplying some of the resources and the rest being supplied by outside parties. The two cases bring out the accounting equation also called book- keeping equation Case one: owner supplying all the resources In this case we say that- Resources in the business = Resources supplied by the owner…………… (i) Resources in business are called assets and resources supplied by the owner are called capital Therefore equation (i) can be re -written as- ASSETS = CAPITAL Case two: resources supplied by owner and outside parties In this case we say that- Resources in business = Resources supplied by the owner + Resources supplied by out- side parties……………………………………………… (ii) The new term in the equation is resources supplied by out side parties, in accounting, we call them liabilities. Therefore equation (ii) can be re-written as- 17 ASSETS = CAPITAL + LIABILITIES……………………………………… (ii) 2.2 Components of accounting equations Assets: An asset is a resource controlled by a business entity/firm as a result of past events for which economic benefits are expected to flow to the firm. An example is if a business sells goods on credit then it has an asset called a debtor. The past event is the sale on credit and the resource is a debtor. This debtor is expected to pay so that economic benefits will flow towards the firm i.e. in form of cash once the customers pays. Assets are classified into two main types: i) Non current assets (formerly called fixed assets). ii) Current assets. Non current assets are acquired by the business to assist in earning revenues and not for resale. They are normally expected to be in business for a period of more than one year. Major examples include  Land and buildings  Plant and machinery  Fixtures, furniture, fittings and equipment  Motor vehicles Current assets are not expected to last for more than one year. They are in most cases directly related to the trading activities of the firm. Examples include:  Stock of goods – for purpose of selling.  Trade debtors/accounts receivables – owe the business amounts as a resort of trading.  Other debtors – owe the firm amounts other than for trading.  Cash at bank.  Cash in hand. Liabilities: These are obligations of a business as a result of past events settlement of which is expected to result to an economic outflow of amounts from the firm. An example is when a business buys goods on credit, then the firm has a liability called creditor. The past event is the credit purchase and the liability being the creditor the firm will pay cash to the creditor and therefore there is an out flow of cash from the business. Liabilities are also classified into two main classes. i) Non-current liabilities (or long term liabilities) ii) Current liabilities. Non-current liabilities are expected to last or be paid after one year. This includes long-term loans from banks or other financial institutions. Current liabilities last for a period of less than one year and therefore will be paid within one year. Major examples: 18 Trade creditors or accounts payable – owed amounts as a result of business buying goods on credit. Other creditors - owed amounts for services supplied to the firm other than goods. Bank overdraft - amounts advanced by the bank for a short-term period. Capital: This is the residual amount on the owner’s interest in the firm after deducting liabilities from the assets. The Accounting equation can be expressed in a simple report called the Statement of financial position (formerly, balance sheet). The basic format is as follows: Name Statement of financial position as at 31.12. Sh Sh Non Current Assets Sh Sh Capital xx xx Non Current Liabilities Land & Buildings Plant & Machinery xx Loan Fixtures, furniture & fittings xx Motor vehicles xx Current liabilities Current Assets xx Overdraft xx Creditors xx xx Stocks xx Debtor’s xx Capital and Liabilities Cash at bank xx Cash in hand xx xx xx Total assets xx The above format of the statement of financial position is the horizontal format however currently the practice is to present the Statement of financial position using the vertical format which is shown below. Name Statement of financial position as at 31.12. 20xx Shs. Shs. Shs. Non Current Assets xx Land & Buildings xx Plant & Machinery xx Fixtures, furniture & fittings xx Motors vehicles xx xx Current Assets Stocks/inventories xx Debtors/ trade receivables xx Cash at bank xx Cash in hand xx xx Current Liabilities Bank Overdraft xx Creditors/trade payables xx xx xx Net Current Assets xx Net assets xxx Capital xxx Non current liabilities Loan (from bank or other sources) xx Total Capital & liabilities xxx Pay attention to the format. The non current assets are listed in order of permanence as shown i.e. from Land and Buildings to motor vehicles. The current assets are listed in order of liquidity i.e. which asset is far from being converted into cash. Example, stock is not yet sold, (i.e. not yet realised yet) then when it is sold we either get cash or a debtor (if sold on credit). When the debtor pays then the debtor may pay by cheque (cash has to be banked) or cash. The current liabilities are listed in order of payment i.e. which is due for payment first. Bank overdraft is payable on demand by the bank, then followed by creditors. Note that in the vertical format, current liabilities are deducted from current assets to give net current assets. This is added to Non Current assets, which give us net assets. Net assets should be the same as the total of Capital and Non Current Liabilities. 20 Example 1.2 C.Murungi sets up a new business. Before he actually sells anything he has bought motor vehicles of Sh.3, 000, premises of Sh.7, 000, stock of goodsSh.2,000. He still owesSh.800 in respect of them. He had borrowed Sh.4,000 from D Evans. After the events just described and before trading starts, he hadSh.300 cash in hand andSh.600 cash at bank. You are required to calculate the amount of his capital. Solution Asset Sh Sh Motor Vehicle 3,000 Premises 7,000 Stock 2,000 Cash at bank 600 Cash in hand 300 12,900 Liabilities creditors 800 Loan- D Evans 4,000 (4,800) 8,100 Capital 8,100 Remember the Accounting equation: Assets = Liabilities + Capital. To get capital we rearrange the equation as follows: Capital = Assets - Liabilities Total Assets =Sh.12,900 Total Liabilities =Sh.4,800 Capital =Sh. 12,900 - 4,800 =Sh. 8,100 Example 2.2 D Moody has the following assets and liabilities as on 31 April 2002: Sh. Creditors 15,800 Equipment 46,000 Motor Vehicle 25,160 Stock 24,600 Debtors 23,080