General

Basic accounting equation…learnings from CFA

Andrew Omeike Written by Andrew Omeike · 4 min read >

The last time we examined the financial statements, which we said are 4+1 in number as follows:

  1. Statement of financial position (Balance sheet)
  2. Statement of comprehensive income (Income statement)
  3. Statement of cash flows
  4. Statement of changes in equity (shareholders equity)
  5. Notes to the financial statements

All the afore mentioned financial statements were briefly explained and distinctions briefly explained. Today, we shall look at what is called the basic accounting equation, as quoted below:

ASSETS = LIABILITIES + EQUITY

The above equation is also known as the dual aspect concept of accounting. Here, if an asset increases, the amount of the increase must be matched by:

a.) a decrease of an equal amount in one or more other asset accounts

b.) an increase of an equal amount in one or more liability accounts

c.) an increase of an equal amount in one or more equity accounts

d.) some combination of the above.

The fundamental accounting equation states that at any point in time, from the balance sheet, the sum total of the assets on the left-hand side (LHS) must be equal to the sum total of the liabilities and equity on the right-hand side (RHS); that is to say that the net impact on the LHS is equal to net impact on the RHS.

We shall put this concept into practice by working through the practice case below:

CBC EMEA limited provides ICT solutions and services in the heart of Lagos. Its services included server installation and repairs. It charged $15 per hour to its client and paid its service staff $7 per hour. CBC began operations in January 2012. During the month of January, the following events occurred:

January 2: CBC’s investors contributed a total of $10,000 in cash

January 12: $3,000 of supplies of paint were purchased but payment will be due in 30 days.

January 14: Clients paid for 125 hours of work and completed in two weeks.

January 15: Service staff was paid for the 125 hours of work that was completed.

January 16: The technical lead was paid $1,000 for one week.

January 20: $1,000 of additional supplies were purchased and payment made in cash, but no supplies were used during January.

January 28: Clients paid for 150 hours of work.

January 29: service staff were paid for the 150 hours of work that was completed.

January 31: The technical lead was paid for another two weeks of work.

We shall prepare a balance sheet for CBC as of January 31, 2012. To do so, we draw up a basic balance sheet format, and make entries to the appropriate accounts for each event stated above.

          ASSETS                                                                                  LIABILITIES + EQUITY

Cash                                 Supplies Inventory                            Account Payable            Contrib.Cap

(2)   +10,000.              (12)    +3,000.                                    (12)  +3,000                   (2)  +10,000

(14)   +1,875.               (20).  +1,000                                                3,000                             10,000

(15).    -875.                              4,000                                               

(16).  -1,000                                                                                                                       Ret.Earngs

(20)   -1,000                                                                                                                       (14)  +1,875

(28)  +2,250                                                                                                                       (15)     -875

(29)  -1,050                                                                                                                        (16)   -1,000

(31)  -1,000                                                                                                                        (28). +2, 250

          9,200                                                                                                                         (29).   -1,050

                                                                                                                                             (31)    -1,000

                                                                                                                                                             200

Total assets = $13,200                                                   Total liabilities + equity = $13,200

Having made the correct entries, we see that the total assets is equal to the sum of all the liabilities and equity. This fulfils the fundamental accounting equation. The account is said to be balanced.

The formal balance sheet looks as follows:

CBC EMEA LIMITED

Balance sheet as of January 31, 2012

Assets                                                                                              liabilities & equity

Cash                                  $9,200                                      accounts payable                       $3,000

Supplies inventory.          $4,000                                      total current liabilities                $3,000

Total current assets       $13,200       

                                                                                             Non-current liabilities                         0

                                                                                             Total liabilities                             $3,000

                                                                                             Owners’ equity

                                                                                     Contributed capital.                  $10,000

                                                                                     Retained earnings                        $200

Total assets.                    $13,200                                    Total liabilities & equity.           $13,200

Notes:

  1. 14 January increase in Ret.Earngs is as follows: 125 hours @ $15/hour = $1,875
  2. 15 January decrease in Ret.Earngs is as follows: 125 hours @ $7/hour =     $875  
  3. 28 January increase in Ret.Earngs is as follows: 150 hours @ $15/hour = $2,250
  4. 29 January decrease in Ret.Earngs is as follows: 150 hours @ $7/hour = $1,050

Andrew Omeike

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