## Sunday, 7 March 2010

### The Accounting Equation - How it Works

As its name suggests, the accounting equation should always balance. If it does not, it suggests that there are basic errors in the accounting system. In other words, it suggests a fundamental error. The accounting equation holds that what the business owes (to the owner and creditors) should be equivalent to what it owns. Each transaction has an equal and corresponding effect on either side of the accounting equation.

When drawing up accounts, there is a left and right side of the account. By convention, the left side of the account is the debit side while the right side is the credit side. If you enter a transaction on the debit side of an account, there should be a transaction on the credit side of another account as well. It is important to note the definition of debit and credits as well.

- Debit- Increase in an asset, increase in expense, increase in drawings
- Decrease in capital, decrease in revenue, decrease in liability
- Credit- Increase in capital, increase in revenue, increase in liability
- Decrease in asset, decrease in expense, decrease in drawings

So far, we have Assets = Capital, which is £20,000.00 on either side of the equation (Dr Asset, Cr Capital). Suppose the business buy goods for sale. The business uses £3,000.00 cash to purchase the goods. This would only affect the left side of the equation, because one asset (cash) is used to purchase another (goods). Assets would still be £20,000.00, but the transaction would be to credit cash (decrease in cash) and debit purchases. The business owns its purchases, so in the balance sheet, it should be recorded as Stock or Goods. Note that the business still owes £20,000.00 to the owner.

The business buys a motor vehicle, using a loan for £5,000.00. The motor vehicle is an asset to the business, but it was purchased on credit. Therefore, the assets of the business would increase by £5000.00, while the liabilities of the business would increase from zero to £5000.00. The accounting equation would be:

Assets (£17,000.00 cash + £3,000.00 goods + £5000.00 motor vehicle) = Capital (£20,000.00) + Liabilities (5000.00).

Now, let us assume that the owner takes exactly half of the goods (£1500.00) from the business and the business sells the remaining goods for £2000.00 cash. The £1500.00 that the owner took is drawings. Now, some folks think that the drawings can only be cash, but drawings are anything that the owner takes from the business, regardless of what it is called. The latter part comes in because if the owner works in the business and pays himself, he might call it wages/ salary. However, because of the business entity concept, which treats the owner's activities as separate from the business, that is drawings as well.

In this case, drawings reduce the stock of the business (asset reduction). Drawings also reduce capital. Therefore, the revised accounting equation would be:

Assets (£17,000.00 cash + £1500.00 goods + £5000.00 motor vehicle) = Capital (£18,500.00) + Liabilities (£5000.00)

Now, we also mentioned that the business sold the remaining goods (worth £1500.00) for £2000.00 dollars cash. Therefore, that transaction increases cash by £2000.00 but reduces to stock from £1500.00 to zero (Increase in cash: Dr £2000.00; Decrease in stock: Cr £1500.00). Wait! There is a difference of £500.00. Notice that the £2000.00 effectively represents sales and £1500.00 represents purchases. Therefore, the additional £500.00 is gross profit. For the accounting equation to balance, that profit must go on the right side. The business did not borrow the £500.00, so it cannot be a liability. Profit is what the business owes to the owner. As such, retained profit increases the capital by £500.00.

That example shows the logic behind the accounting equation. Every business transaction has an effect on the accounting equation and this is reflected in the Statement of Financial Position (Balance Sheet). However, since an entity performs several transactions within a period, it is difficult and impractical to create a balance sheet after every transaction. This is done at the end of the period to show the assets of a business in relation to its liabilities.

Assets, capital and liabilities are the building blocks of the accounting equation.

### Accounting Terms - Assets, Capital and Liabilities

Assets, liabilities and capital are so essential to accounting, that they form the basis of the accounting equation (Assets = Capital + Liabilities). An asset refers to anything that an entity owns or has control over. Capital is the entity's obligation to its owner or owners, while a liability is anything that the business owes to others besides the owner. Therefore, capital is also a liability or obligation of the business, but it is a special kind as it is owed to the owner.

If you look at the accounting equation, you would recognize that there are other relationships arising from the equation. First, the equation suggests that what the business owns (assets) should be equivalent to what it owes (capital and liabilities). In addition, Capital = Net Assets (Assets - Liabilities).

Assets, which include goods, machinery, buildings and receivables, can be either current assets or non-current assets. Current assets are those that the business expects to realize, in an accounting sense, during the following trading period or in the short term. A non-current asset has a long-term purpose and is one that the business intends to keep. What you must realize is that, while businesses sell non-current assets, when they are purchased, the entity wishes to keep them for longer than one trading period. The asset type is critical in determining the financial position and income of the business. Current and non-current assets have a different effect on the income statement and balance sheet.

Just like assets, liabilities can be either current or non-current. A current liability can be settled within the trading period or short-term, while a non-current liability is one with a longer repayment period. Examples of liabilities include mortgages, credit from suppliers and other payables). A mortgage is an example of a non-current liability; an example of a current liability is "payables."

Capital refers to what the owner or owners invest or put into the business. Anything withdrawn by the owner, for any reason, is called withdrawals or drawings. When a business makes a profit, the business cannot do what it pleases with the profit. The profit is the return on investment for the owner after all. Therefore, if a business makes a profit or loss, it affects the asset position and the capital owed to the owner. Capital can include shares, venture capital or personal funds.

It is interesting to note the relationship between assets and liabilities. A transaction can increase the assets of a business but increase the liability of the business as well. To the uninitiated, this may seem counterintuitive. However, recall that assets refer to what the business owns and controls. If a bank lends the business (not the owner) \$20,000.00 to buy a vehicle, the business does not yet own the vehicle (until it is fully paid off).

However, they control the use of the vehicle, although the bank could repossess it for repayment failure. As such, the liability is also an asset; note that a liability does not form part of Net Assets. The connection between assets, capital and liabilities forms the basis of the double-entry system or duality concept, where all debits equal corresponding credits.

### Economic Order Quantity - An Overview

Inventory management requires classification and determination of inventory costs and measurement of stock levels. In maintaining adequate levels of inventory, it is necessary to order the right amount of inventory at the right time to maximize the benefits of holding inventory against its costs. As such, the Economic Order Quantity (EOQ) determines the "order quantity that minimizes inventory costs."

The EOQ is a function of demand, holding costs (Hc) and ordering costs (Oc). It can be calculated using a formula (that uses the aforementioned variables), table or graph. According to the formula, the Economic Order Quantity is the square root of the quotient of [2 X Ordering Cost of a consignment X Demand/Holding Cost per unit). The graph of the EOQ demonstrates the relationship in a more lucid manner. The EOQ is where the holding cost line intersects the ordering cost curve.

If you refer to how costs are classified in cost accounting, you would realize that holding costs are variable and ordering costs are fixed per order. Therefore, total ordering costs are higher with smaller inventory levels while total Hc rises with the inventory level. The graph demonstrates the relationship between a Total Fixed Cost (Ordering) and Total Variable Cost (Holding). This also explains why the Oc line is a curve and the Hc is a straight line.

The aim of the Economic Order Quantity is to minimize Total Inventory Cost. This occurs where the total Hc is equal to the total Oc. This is logical because there is a trade-off between holding and ordering costs. If you have no inventory, your ordering costs would be exponential-your suppliers would charge for delivery each time, bulk discounts would not be available and staff would be very active in receiving regular orders. However, if you maintain too much inventory you would incur a significant Hc. This is because the business might need more staff, equipment and storage space to handle high inventory levels.

Going back to the concept of inventory levels, recall that the reorder level is: maximum usage X maximum lead time. The maximum level is: Reorder level + reorder quantity - (minimum usage X minimum lead time). Using these, the EOQ dictates how much to reorder when the reorder level is reached. However, by definition, whatever quantity is the optimum amount should not take stock levels past the maximum level. This is because the maximum level serves as a warning when inventory levels are too high for the business to manage properly (and where holding costs are significant).

The EOQ addresses the cost relationship between the holding and ordering costs.

### The Role of Linear Regression Analysis in Costing

Linear regression analysis is a useful technique in business mathematics, among other spheres. In accounting-specifically cost and management accounting-it allows accountants to project costs given a range of values over specific cost periods. It is far superior to techniques such as expected values, scatter graphs and the high-low method in projecting costs and separating the fixed and variable components of semi-variable costs.

Also known as the least squares method, regression seeks to establish values for a linear equation-the line of best fit. It is only one of several methods of establishing the line of best fit. The linear equation, in the form y= a + b(x) represents a cost relationship, where y is the total cost, a is the fixed cost, b is the variable cost per unit and x is the level of activity or output. As such, one can also represent the linear equation in the following formula:

Total Costs = Fixed costs + (Variable cost per unit x output / activity level).

Total costs and the activity level are the related variables in this equation, while pairs of data for fixed and variable cost per unit are estimated based on the pairs of data for Total Cost and activity level.

Regression analysis allows the accountant to glean more information than correlation analysis. Correlation analysis provides a foundation in assessing the strength of the relationship between costs and activity levels. However, it does not provide a means of approximating values on the basis of an assumed linear relationship.

Linear regression analysis uses historical variables as inputs in order to establish the linear relationship between costs and the level of activity. Accountants use the result of regression analysis to predict total costs based on actual data. It is useful as a budgetary tool and can inform the planning and decision-making process.

Linear regression facilitates formation of estimates of complex relationships, particularly where the relationship is not immediately evident. Once the linear relationship is determined, managers can estimate total costs for any level of activity by plotting the information on a graph.

Although linear regression analysis is a useful method of separating semi-variable costs and forecasting, it has its limitations. Naturally, it is based on assumptions of a linear relationship and that Y is exclusively dependent on X. The reliability of predictions of the linear regression method is also predicated on the reliability and validity of the data provided.

Accounting-whether cost, management or financial accounting-relies on information that is meaningful and useful to its users.

### Accounting Principles - Consistency of Presentation

The consistency concept-or consistency of presentation-in financial accounting, is one of four fundamental assumptions of IAS 1 (International Accounting Standard 1), along with going concern, accruals and fair presentation. Consistency holds that accounting methods used in one accounting period should be the same as methods used for events/transactions, which are materially similar, in other periods. Naturally, there are unique circumstances in which entities can change methods and not follow the consistency concept, although there must be good reason for this.

The requirement for consistency reinforces qualitative characteristics of financial statements, such as reliability and comparability. Its aim is to facilitate historical comparisons of financial accounts of an entity. The consistency concept arose because, in accounting, there several methods or techniques to determine valuations or costs. A classic example is depreciation, which can be determined using the straight-line or reducing balance method. Another good example is the application of the historical cost convention or the LIFO (Last in/ First out)/ FIFO (First in/ First out) methods for stock valuation.

For example, assume that ABC Company Ltd. purchases equipment for \$100,000.00 in 20X7. It decides to use the straight-line method of depreciation for that equipment. Two years later, ABC Company Ltd decides that it is more appropriate to use the reducing balance method. Notwithstanding the bases for exemptions from consistency, IAS 1 does not permit ABC to change its method of depreciation for that particular asset. Since it chose the straight-line method for depreciation first, it must stick with it.

The International Financial Reporting Standards are not unreasonably rigid or fixed. Financial accounts can depart from the consistency assumption if:

a) The nature of business operations changes in a material way or a more suitable/fairer method of presentation information is identified.

b) An International Financial Reporting Standard requires a change in presentation

Consistency is an important assumption in the accounting standards because it facilitates comparability for information users. Financial statements for an entity can be properly compared over time because the accounts are treated the same way and the same methods are applied.

In addition, consistency facilitates reliability and fair presentation. It prevents entities from conveniently using methods to skew the financial position of the entity. After all, without consistency, entities would be able to select the methods that represent the best financial position for each period. That would be unethical, since it would be unfaithful presentation and would contradict the principle of prudence as well. It is, therefore, easy to glean the importance of consistency of presentation in financial accounting.

Consistency of presentation also affects the qualitative aspects of financial statements.

### Accounting Principles - The Separate Entity Or Business Entity Concept

he business entity concept holds that a business is a separate entity from its owner or owners, whatever the legal position of the enterprise may be. A business could take several forms, i.e. partnership, sole trader or corporation. These types of business have a certain legal status. For example, sole traders do not have a separate legal status, whereas a corporation has a separate legal status from the owner. That makes the corporation a separate legal entity.

The business entity concept is a principle that applies to all types of organisation. It is so fundamental, that it is one premise for the accounting equation: Assets = Capital + Liabilities. Recall that capital represents the owners' financial input in the business. It is what the business owes to the business owner, in addition to liabilities from external sources (lenders or suppliers, for example).

The business entity concept is also central to the preparation of financial statements. It, along with key accounting assumptions, governs the preparation of statements of financial position and income statements. One primary aspect of this assumption is that it governs the treatment of transactions by owners, even if the transactions are for personal purposes, as in the example of the sole trader.

Sole traders have one legal identity, that is, the sole trader is the same entity as the business. As a result, the sole trader has unlimited liability. However, the business entity concept has implications for the sole trader. The trader cannot treat business funds as his own piggy bank because of this principle.

If the owner (sole trader) deposits or withdraws money from the business, it is a separate from transaction from his personal account. For example, if the owner withdraws money from the business account for personal use, it is recorded as drawings. Any injection or reinvestment of profits would be regarded as capital in the accounting context.

Although profit is healthy for a business, from the business point of view it is viewed as a liability when establishing the financial position of a business. This is because of the enforcement of the business entity concept. Based on this, profit is business' obligation to business owners. It would be up to the owner to decide what to do with the profit. It is not a matter of course that profit could be used for reinvestment, especially when there are multiple owners (investors).

Accounting-whether cost, management or financial accounting-relies on information that is meaningful and useful to its users.

In accounting, overheads refer to indirect costs that are charged to production and other functions or departments. Indirect costs are those that are not fully attributable to a product, service or department. They apply to materials, wages/labour and expenses. As such, it follows that there are indirect materials, indirect wages and indirect expenses for different functions departments that relate to those categories.

Production overheads are also known as factory overheads. These cover indirect costs that are incurred during the completion of a product or provision of a service. Factory overheads include materials that are too negligible in terms of charges or quantity for cost tracing. For example, if you are using 8 screws that cost 50 cents per screw, that amount might be immaterial in relation to other charges associated with the product manufactured.

The commissions or wages of non-productive workers are also part of production overhead. However, if a supervisor does not actually work on the product, he is productive if his salary/wages are directly traceable to a product, service or department. Indirect expenses are another dimension of production overheads. Examples of those include depreciation of equipment and plant maintenance.

In producing a product, an entity will have expenses related to administrative personnel and processing costs-such as stationery. Salaries of office staff and insurance for the business premises are additional overheads that relate to administration.

A product or service must reach clients and there are charges attached to packaging and delivering the goods. Distribution overheads deal with aspects of the completed product and do not include transport fees to other plants before the product is finished. Transport costs, containers or boxes for shipment, wages for drivers, warehousing and insurance for stock are some examples of distribution overheads.

Businesses need to advertise their product or service and maintain their clientele. Indirect costs incurred in doing this constitute selling overhead. Material costs for this function include flyers, brochures and website fees. Labour charges include salaries, commissions and wages for salesmen, clerks and customer service representatives. Expenses including advertising, market research and rent/insurance for showrooms.

Production overhead forms part of production costs. However, overheads in other areas constitute costs that are separate from production costs but included in the TC. The equation for total costs is as follows:

While overheads refer to indirect costs, prime cost refers to the total of direct material, wages and expenses.