Financial Accounting/Session 2
In all businesses from the smallest individual to the largest multinational corporation, a set of financial accounts are kept which detail all financial activity carried on by the business. This is a key requirement allowing the business to keep track of income and expenses as well as assets and liabilities.
In practice, there are some slight differences between companies and sole traders (or partnerships) which revolve around the equity line (as introduced in session 1). Sole traders call this 'Owners funds or owner's equity' generally representing the initial amount of cash they personally inject into the business. Companies however have 'share capital' representing the value in cash of the issued shares of the company. From a pure accounting view point, this difference is not important at this stage.
We will begin by focusing on a sole trader below. We begin by noting that from the outset a trader (or company) will create a Chart of Accounts which is little more than a collection of all the required accounts for business. Each account is used for one type of activity, so examples might be a fixed asset account, a debt account, a cash account and an equity account. These four accounts together would make up the chart of accounts. It is important to note that there is no fixed amount set in stone. A small trader may have a single Expenses account, but a large company may split this into many smaller accounts for wages, tax, telephone costs, paper and so on.
As an example, lets select a very simple set of accounts for an individual, Pat, who pays cash for everything, but sometimes writes an IOU if there's not enough cash on hand. Pat has no checking or savings account, owns no house or car or stocks, saving nothing except cash on hand and personal property for later. Pat's chart of accounts might include the following:
- Cash on hand
- Personal property
- Accounts payable
- Pat's Equity
Now let's consider a few transactions in the accounts.
(1) Pat works all day and is paid $50 in cash at end of day
- Dr Cash on hand $50.00
- Cr Pat's Equity $50.00
To record receipt of cash for day's work
(2) Pat spends buys $20 of food, but only pays $15 cash, and writes an IOU for the remaining $5.00
- Dr Personal Property $20.00
- Cr Cash $15.00
- Cr Accounts payable $5.00
To record purchase of food with cash and IOU
How do Pat's accounts look after transaction (2)? The accounts have the following balance:
- Cash on hand has a Debit balance of $35.00
- Personal property has a Debit balance of $20.00
- Accounts payable has a Credit balance of $5.00
- Pat's Equity has a Credit balance of $50.00
Or, writing these balances as T-Accounts:
Cash on hand
0.00 | 5.00
- Owner's Equity
0.00 | 50.00