Mr.
Motlhatlhana Mokgokone
FAC1502 – Study unit 1- 4
Basic Accounting Equation (BAE) and Double
Entry System
Purpose of this lecture:
Understand elements of financial statements.
Understand components of financial statements.
Understand BAE.
Understand the behavior of each element in the BAE and in
general ledger (T-account).
Understand how income and expenses affect equity in the
BAE.
Understand each element of financial statements definition,
recognition and example of items that fall under each
element.
Do class exercise
Components of financial statements
1. Statement of financial position
2. Statement of profit or loss and other
comprehensive income
3. Statement of changes in equity
4. Statement of cash flows
5. Notes to the financial statements
Elements of financial statements.
Elements to be disclose in the statement of financial
position are (assets, equity and liabilities).
1. Assets
2. Equity
3. Liabilities
Elements to be disclose in the statement of profit or loss
and other comprehensive income.
4. Income
5. Expenses
Basic Accounting Equation (BAE)
ASSET = EQUITY + LIABILITIES
BAE is a mathematical equation, and it should always
balance.
The equation must be balanced after each transaction.
Debit side must be equal to Credit side.
A minimum of two accounts must be used for each
transaction.
Accounting equation is based on double entry system:
Which accounts will be affected by the transaction?
Which account to be Debited and which account to be Credited?
The effect the transaction has on the BAE
BAE can be re-arranged as EQUITY= ASSET - LIABILITIES
Behavior of each element in the BAE and in general
ledger (T-account).
Dr. Asset Cr. Dr. Equity Cr.
+ _ _ +
Increases Decrease Decrease Increase
Dr. Liabilities Cr.
Dr. Expenses Cr. _ +
_
+ Decrease Increase
Increase
Decrease Dr. Income Cr.
_ +
Decrease Increase
Understand how income and expenses affect equity in
the BAE.
Dr. Equity Cr.
_ +
Decrease Increase
Dr. Expenses Cr. Dr. Income Cr.
_ _ +
+
Increase Decrease Increase
Decrease
Definition and recognition of each element in the
financial statements
1. Assets
A resource controlled by the entity as a result of past events,
from which future economic benefits are expected to flow to
the entity.
Examples of assets includes:
Trading inventories
Consumable stores on hand
Debtors/trade receivables
Accrued income (it an asset)
Prepaid expenses (it an asset)
Bank (favourable balance)
Cash float
Petty cash
Definition and recognition of each element in the
financial statements Continue….
Examples of assets includes:
Land
Buildings
Vehicles
Furniture
Equipment
Machinery
Assets are recognised in the financial statement of an
entity when:
It is probable that the economic benefit will flow to an entity, and
The cost or value of asset can be measured reliable
Definition and recognition of each element in the
financial statements Continue….
Assets are classified into two categories, namely;
Current asset
Non-current assets
For an asset to be classified as current asset, it must
meet any of the following criteria:
It is expected to be converted into money (realised) or is intended for
sale or consumption in the entity’s normal operating cycle.
It is held primarily for the purpose of being traded.
It is expected to be converted into money (realised) within 12
months of the statement of financial position date.
It is cash or cash equivalent unless it is restricted from being
exchanged or used to settle a liability for at least 12 months after the
end of the reporting period.
Definition and recognition of each element in the
financial statements Continue…….
Examples of current assets:
Trading inventories
Consumable stores on hand
Debtors/trade receivables
Accrued income (it an asset)
Prepaid expenses (it an asset)
Bank (favourable balance)
Cash float
Petty cash
Definition and recognition of each element in the
financial statements Continue….
For an asset to be classified as non-current asset, it must
meet any of the following criteria:
All other assets (that is, assets that are not classified as current assets
are classified as non-current) (IAS 1.60).
It is not the intention of the entity to sell non-current assets but to
use these assets over the long-term in its business operations to earn
an income.
Non-current assets are those assets with a useful life of longer than
one year.
Examples of non-current assets; Land, Buildings, Vehicles,
Furniture, Equipment, Machinery.
Definition and recognition of each element in the
financial statements
2. Liability
A liability is a present obligation of the entity arising from past
events, the settlement of which is expected to result in an
outflow from the entity of resources embodying economic
benefits.
Examples of liabilities includes:
Creditors/trade payables
Bank overdrafts
Current portion of long-term borrowings
Short-term borrowings
Accrued expenses
Income received in advance
Definition and recognition of each element in the
financial statements
Examples of liabilities includes:
Long-term loans
Mortgage
Debentures
Liabilities are recognised in the financial statement of an entity when:
It is probable that there will be an outflow of economic benefits when
present obligation is being settled.
The amount of settlement can be measured reliable.
Definition and recognition of each element in the
financial statements Continue….
Liabilities are classified into two categories, namely;
Current Liabilities
Non-current Current liabilities
For a liability to be classified as current liability, it must
meet any of the following criteria:
It is expected to be settled in the entity’s normal operating cycle
(usually one year).
It is held primarily for the purpose of being traded.
It is expected to be settled within 12 months after the statement
of financial position date.
The entity does not have an unconditional right to defer settlement of
the liability for at least 12 months after the end of the reporting period.
Definition and recognition of each element in the
financial statements Continue….
Examples of current liabilities:
Creditors/trade payables
Bank overdrafts
Current portion of long-term borrowings
Short-term borrowings
Accrued expenses (It a liability)
Income received in advance (it a liability)
Definition and recognition of each element in the
financial statements Continue….
For a liability to be classified as non-current liability, it
must meet any of the following criteria:
All other liabilities (that is, liabilities that are not classified as current
liabilities are classified as non-current) (IAS 1.69).
Non-current liabilities are long-term debts and have to be settled
after one year of the statement of financial position date.
Examples of non-current liabilities:
Long-term loans
Mortgage
Debentures
Definition and recognition of each element in the
financial statements Continue….
3. Equity
Is the residual interest in the assets of the entity after deducting all its
liabilities:
EQUITY = ASSET LESS LIABILITIES
The Wealth of the owners of the entity
Let assume FAC Traders have the following assets and liabilities:
Equipment R200 000
Trade receivables R50 000
Bank R50 000
Loan from ABC Bank R100 000
Trade payables R40 000
Calculate Equity of FAC Traders
EQUITY= R300 000 (total assets) less R140 000 (total liabilities)
= R160 000
Definition and recognition of each element in the
financial statements Continue….
Alternatively, Let assume FAC Traders had the following balances
(Owner is Mr. FAC):
Capital (opening) R120 000
Equipment R200 000
Trade receivables R50 000
Bank R50 000
Loan from ABC Bank R100 000
Trade payables R40 000
Income R110 000
Expenses R50 000
Drawings R20 000
Determine Equity of FAC Traders using statement of changes in
equity.
Definition and recognition of each element in the
financial statements Continue….
Determine Equity of FAC Traders using statement of changes in equity.
Statement of changes in equity of FAC Traders.
Capital
Opening balance R120 000
Profit for the year (R110 000- R50 000) R60 000
Less: Drawings (R20 000)
Closing balance R160 000
Definition and recognition of each element in the
financial statements Continue….
4. Income
Income definition refers to both revenue and gains
Revenue is income earned through an entity’s normal activities (daily
operating activities). Examples of revenue includes;
Fees earned
Sales
Interest income
Rental income
Commission income
Credit losses recovered
Gains are increases in economic benefits that do not arise from the
normal activities of an entity. Example includes;
Profit on the sale of non-current assets.
Definition and recognition of each element in the
financial statements Continue….
Income is recognised when :
• An increase in economic benefits through an increase in assets or a
decrease in liabilities of an entity has arisen for the entity.
• It can be measured reliably.
Definition and recognition of each element in the
financial statements Continue….
5. Expenses
Expenses definition refers to losses as well as those
expenses that arise during the ordinary activities of an entity.
Expenses are incurred in the normal course of an entity’s
activities. They arise from the generation of income.
Examples includes; cost of sales • a loss on the sale of a non-
current asset • wages and salaries • interest expenses • rental
expenses • advertising • credit losses • insurance • repairs and
maintenance • telephone expenses • water and electricity • postage •
rates and taxes • stationery • consumables • packing materials •
bank charges • depreciation • administrative expenses.
Losses are decreases in economic benefits that do not arise from
the normal activities of an entity, for example, a loss on the sale of a
non-current asset.
Definition and recognition of each element in the
financial statements Continue….
Expenses are recognised when :
• A decrease in economic benefits through a decrease in assets or an
increase in liabilities of an entity has arisen for the entity.
• It can be measured reliably.
Definition and recognition of each element in the
financial statements Continue….
Expenses are recognised when :
• A decrease in economic benefits through a decrease in assets or an
increase in liabilities of an entity has arisen for the entity.
• It can be measured reliably.
Analyzing of a transaction
When analyzing a transaction, the following
questions needs to be asked?
Transaction is any activities occurred within the financial period of the
business
Which accounts will be affected by the transaction?
Do the accounts form part of assets, equity or liabilities?
Did the assets, equity or liabilities increase or decreases?
Which account to be debited and which account to be credited?
