Financial Accounting Equation – Lesson Seven

I have purposely left introducing the Financial Accounting Equation to the final part of my free bookkeeping course. If you are intending to study bookkeeping and accounting then almost certainly you will encounter the accounting equation within the early pages of your studies. It is sometimes stated that double entry bookkeeping is based on the financial accounting equation. Maybe, but students have more trouble with the accounting equation than any other part of bookkeeping and accounting.

My Teaching Experiencefinancial accounting equation

When I agreed to teach bookkeeping and accounting to adult evening classes I was told that the course had a high drop-out rate after the second lesson. The reason was obvious – I was an accountant and I found the accounting equation confusing – the students, having reached lesson two were coming to the conclusion that this course was far too difficult for them.

If only the teaching of bookkeeping followed my method, included in this course, then we would not have such a shortage of bookkeepers. My dislike of the accounting equation is my prime reason for writing this course with the simple Rules 1 to 4, which we have followed throughout. We completed our double entry recording and took out a trial balance to confirm our total debit entries values equaled the total value of our credit entries. The trial balance is then used to prepare a Trading and Profit and Loss Account which leads on to the Balance Sheet. Again we have to ensure each side of the balance sheet adds to the same total.

The Balance Sheet Re-visited

In Lesson five I gave you an exercise to state whether you would expect to see a debit or credit entry against each of the items you might encounter in the balance sheet. Using Rules 1 to 4 you were able to complete this task. As I said early in this course, bookkeeping is easy, taught the right way. The wrong way of teaching, in my opinion and experience, is to introduce the Balance Sheet (which is the accounting equation) at the beginning of your course.

Had I followed the usual way of teaching this subject the following would have been introduced to you very early on and would have been a substitute for my basic rules:

Assets = Liabilities + Capital

The basic accounting equation shows the relationship between Assets, Liabilities and Capital. Capital is sometimes referred to as Owners Equity in the equation.

Assets are things the business owns, Liabilities the amounts the business owes and Capital is the investment made by the owner(s).

Assets = Liabilities + Owners Equity

The sides of the equation must always balance.

If we buy an asset, to maintain equilibrium we could have a decrease in the value of another asset OR an increase in our liabilities.

Assets are Debits. Liabilities and Owners Equity are Credits.

Let us add a few figures to the equation, we have purchased a van for the business so our assets have increased. To maintain the balance another asset must be reduced or there has been an increase in our liabilities.

Cash Purchase of Asset

Our van cost £10,000 and in our first example we have paid for this in Cash. Our van is an asset; an increase in our assets will be a debit of £10,000. Cash is also an asset (it is something we own) and our cash balance has been reduced having paid out £10,000; the reduction in the value of an asset is a credit. One asset has increased by £10,000 and another asset has been reduced by £10,000 – there is no change to our equation.

Credit Purchase of Asset

If we had purchased our van on credit we would have had to consider the transaction on the following basis. Our asset has increased by £10,000 as before but now we have a Liability as we owe our garage for the van. When we increase our liabilities we credit that account. Our equation still balances as we have increased both sides by £10,000.

(Which would you have preferred to learn, the above or my Rules 1 – 4? Don’t answer, I think I know.)

Purchase of an Expense Item

(Now we’ll get really complicated)

We have our van serviced at a cost of £580. The service cost is an expense to the business.

Now the equation has to be extended, firstly to

Assets = Liabilities + Owners Equity + Profit

What is Profit? Profit is Income – Expenses, our extended equation is

Assets = Liabilities + Owners Equity + Income – Expenses

But we would prefer to show our debits on one side of the equation and our credits on the other as follows

Assets + Expenses = Liabilities + Owners Equity + Income

Our £580 van service was an expense which we can see is on the debit side. The credit entry would be the same as the van purchase above, paying cash would be a reduction of our assets, buying on credit would increase our liabilities.

At this stage of the course you may be able to follow the logic of the above but just imagine the difficulty had I introduced it early on instead of the “easy-learning” rules 1 – 4.

Course Conclusion

We have reached the conclusion of my seven part course and I would like you to just read through my summaries of how I have intended to target all interested parties. Included are:

Thinking of Training as a Bookkeeper or Accountant?

Office Workers

Mums or Dads at Home

Senior Citizens

Owners and Managers of Small Businesses

Sole Trader/Small Business

For Those Who Can Foresee Themselves Starting a Business in the Future

Thinking of Training as a Bookkeeper or Accountant?

The course has been fairly comprehensive with you in mind. If you have found the lessons interesting and not too difficult to follow then training for a professional qualification is within your grasp. Recently the widely respected AAT, Association of Accounting Technicians, launched a professional bookkeeper qualification and this is the program I regard as the most desirable. AAT students worldwide are highly employable and you may be successful in joining an Accountant’s practice where they will pay for your studies. For information about the AAT click here.

Office Workers

Having read this course I would suggest purchasing a bookkeeping/accounting text book and extending your knowledge. An understanding of the full bookkeeping picture will give you the advantage over other job seekers and showing initiative and desire to progress should bring rewards.

Mums and Dads at Home

Studying in readiness for the return to work as your family grows up and perhaps taking up some part-time bookkeeping work you can fit in with the school hours. This studying might follow the above suggestion for office workers or perhaps you have the finances to take the AAT home study course.

Senior Citizens

It’s never too late to learn new skills. As an alternative to bookkeeping you might care to consider the challenge of learning to create websites, write blogs and research subjects of interest. My article “Simple Website Tutorials” can be accessed by clicking here. Keep in touch with today’s fast developing technology.

Owners and Managers of Small Businesses

It is important that owners and managers have an over-view of the accounting system within their business. If you are using a computerized system, that system can be set up to provide you with whatever level of information you consider appropriate to your organization.

Reports giving the listing of outstanding debts (both the debts you owe and also the amounts owed by your customers) are essential and need to show the amounts that are overdue – these are usually the first indications of customers experiencing difficulties. If amounts you owe your suppliers includes overdue items this could be hiding a cash-flow problem building within your own business.

You can organize a separate sales account for each product and have reports which will give an early warning of a sales line “dropping-off”. Are you over stocked with certain products or materials? Individual customers can be observed to compare the sales you have achieved with them this year to the same time last year. Why have sales to customer X been much lower this year?

Cash flow is the lifeline of a business. Each month you can estimate from the Aged Debtor Analysis how much you can expect to receive over the coming month and your Aged Creditor Analysis will show haw much you are due to pay out. You can assess your outgoings for the month and calculate how much would be left in your account at the end of the month. From the balance left you need to deduct amounts you will need to set aside for future higher expenditure months, for example your insurances for the year may fall due for payment in one month. You may have tax to pay and you may be planning some major asset replacements or additions. If your business is seasonal then this creates its own problems for cash flow.

With computerized accounting you should be able to set up your bookkeeping/accounting systems to provide the information you need to maintain a tight control over your business.

Sole Trader/Small Businesses

The manual double entry bookkeeping system tends to be on its last legs. There are some free computerized systems available on the internet. There are also some useful books where you add your income, expenditure, bank records etc. in accordance with the instructions provided. A very popular range of books are “The Best Small Business Accounts Book” by Peter Hingston with versions for non-VAT registered Small Businesses and VAT registered.

The yellow version of these books is only suitable for non-VAT registered businesses such as the Self Employed, Beauticians, Chiropodists, Cleaning Services, Driving Instructors, Garden Services, Hairdressers, Market Traders, Painters and Decorators, Taxi Drivers and many similar businesses.

The blue book has two versions, one of these being for VAT registered businesses and may include Builders and Contractors, Consultants, Hauliers, Property Maintenance, Tradespeople and similar.

Most Important for all Businesses

You must differentiate between you and your business. Whatever the business entails it is a SEPERATE ENTITY. There is you and there is your (decorating etc.) business

For Those Who Can Foresee Themselves Starting a Business in the Future

Recent surveys indicate that almost a third of 16-34 year olds are considering self employment.

40% of us want to be our own boss but only 1 in 20 of us have any plans for starting.

Almost a quarter of UK workers are considering starting and running a business within the next two years to run alongside their occupation. A report by GoDaddy shows that one half of employees with a sideline business make between £500 and £5,000 extra income every year.

Now is the time to learn whilst under no pressure and be prepared when the opportunity arises. Learning in advance the basic requirements for bookkeeping along with being able to create your own website will leave you time to concentrate on the core of your business.

My article “Simple Website Tutorials” can be accessed by clicking here.

 

If you have any comments or questions on the above, please leave them in the area below and I will be very pleased to help you out.

 

Colin

 

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