Bookkeeping Concepts – Classification of Accounting Transactions & the Basic Accounting Equation
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In this article I start off by defining the important classifications of accounting transactions. The most basic transactions are classified as Assets, Liabilities and Owner’s equity. To reinforce your understanding, I have applied each definition to realistic examples where possible. I then explore the relationships between the three classifications which make up the basic Accounting Equation as well as the debit and credit rules. Let’s begin. Definition of Assets Assets are physical (tangible) or non physical (intangible) economic resources controlled by an entity which provide a future economic benefit to that entity, as a result of a past transaction or other events. Let’s break this definition down and apply it to an example.
A business which sells furniture (Furniture Co.) purchases a cash register to use on their premises. The cash register is classified as an asset as it is a physical (tangible) object (although assets can also be intangible such as patent rights) controlled by an entity, (the Furniture Co.) which provides future economic benefit to that entity (storing cash, printing receipts, calculating change etc, all of which are benefits to the Furniture Co.) as a result of a past transactions or other events (the purchase of the cash register is the past event) Assets can be further classified into current and non current assets. Current assets are those assets whose flow of economic benefits to the entity will cease within 1 year. Non current assets are assets which provide greater than 1 years of economic benefit.
List of common assets in a business (non exhaustive).
Current assets
Cash at bank
Petty cash Inventory
Accounts receivable
Prepaid rent
Office supplies
Non current assets
Motor vehicles Office equipment
Plant and equipment
Definition of Liabilities — Liabilities are future sacrifices of economic benefit, that an entity is obliged (at present) to make to another entity as a result of a past transaction or other event. Liabilities are generally settled through the payments of cash, swapping an asset or performance of a service etc. Let break this definition down and apply it to a Furniture Co. example. Furniture Co. took out a bank loan for $25 000. The borrowed amount of $25 000 will eventually be paid back to the bank. The eventual repayment (and interest repayments) of this amount in the future is the future sacrifices of economic benefit. Furniture Co. would have signed a loan contract with the bank, which binds them and ensures that they are obliged to make these future sacrifices of economic benefit to another entity (the bank) as a result of a past transaction or other event (signing of the loan contract and transfer of loaned amount) Liabilities can be further classified into current and non current liabilities.
Current liabilities are those debts which are to be completely settled within 1 year. Non current liabilities are debts which are not expected to be settled within the next year. List of common liabilities of a business (non exhaustive). Current liabilities Short term loans Accounts payable Salaries payable Interest payable Non current liabilities Long term loans (business loans/mortgage) greater than 1 year Definition of Owner’s Equity Owner’s equity is the owner’s rights to the assets of the business. Recall the basic accounting equation below. When we rework this equation, we can clearly see that owner’s equity is simply business assets minus liabilities Assets = Liabilities + Owner’s Equity To rework this Owner’s Equity = Assets – Liabilities The basic Accounting Equation
Assets = Liabilities + Owner’s Equity After understanding the 3 concepts above, this equation should make sense to you. Think about it this way, all the assets in a business can either be obtained through Purchases, funded from Borrowings (liabilities)Cash contributed into the business by the owner (owner’s equity)
OR
Contributed as capital assets into the business by the owner — Therefore
Assets = Liabilities + Owner’s Equity
What your business owns (assets) = the amount of borrowings (liabilities) + the amount of capital contributed to the business by the owner/s (owner’s equity) Debit & Credit Rules These debit and credit rules are the backbone of basic bookkeeping concepts and need to be understood and memorized. Classification of Increase Decrease Transactions and accounts Asset Debit Credit Liabilities Credit Debit Owners Equity Credit Debit A useful way of remembering these rules is to think of the accounting equation below Given that assets, liabilities and owner’s equity are increasing
LHS = RHS
Debit = Credit
Assets = Liabilities + Owner’s Equity Assets are on the LHS of the accounting equation = debit. Both liabilities and owner’s equity are on the RHS of the accounting equation, therefore an increase = credit To summarize, I have explained the basic principles underlying bookkeeping and accounting. To be successful as a bookkeeper or accountant, you must first have a strong understanding of these fundamentals. I would advise that you re-read this article again to strengthen your understanding of these basics before moving on to more advanced topics.
