The Framework of Financial Statements
2.3 The accounting equation
The accounting equation shows that AssetsLiabilitiesCapital What do these terms mean?
Asset. A resource that may be used by a business or other organisation to derive revenue in the future.
Examples of assets are land, buildings, plant and machinery, motor vehicles, invento-ries of goods, receivables, bank balances and cash. Assets may be described as tangible or i ntangible . Tangible assets are those that can be physically seen or touched (e.g. land, build-ings, equipment, inventories, etc.). Intangible assets cannot be physically seen or touched (e.g. goodwill, which represents the value of a business as a whole compared with the sum of the values of its individual assets and liabilities). As such, goodwill represents the value of the organisation’s customer base, employee relationships, and so on. Other intangible assets might include patents and trademarks. You will learn more about intangible assets in Chapter 10.
Receivables. A person owing money to an entity.
These are assets to the business because they are eventually converted into cash, which is a resource that can be used by the business.
Liability. An entity’s obligations to transfer economic benefi ts as a result of past transac-tions or events.
Thus a liability can be described as an amount owed by a business or organisation to an individual or other business organisation. Examples of liabilities are payables, loans received and bank overdrafts.
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Payables. A person or an entity to whom money is owed as a consequence of the receipt of goods or services in advance of payment.
These are fi nancial obligations or liabilities of a business until they are paid. These lists of assets and liabilities are not exhaustive, and you will encounter other examples as your studies progress.
Capital. In this context, capital is diffi cult to defi ne, but it can be regarded as a special kind of liability that exists between a business and its owner(s).
To return to the accounting equation, you can perhaps see that the assets of an organi-sation have been provided, or ‘ fi nanced ’ , by liabilities either to outsiders or to the owner.
This emphasises the importance of the separate entity concept described above. Because we regard the owner as being separate from the business, we can regard the amount owed by the business to its owner as a kind of liability. Effectively, we can restate the accounting equation in an even simpler form:
Assets of the businessLiabilities of the business
This statement is always true no matter what transactions the business undertakes. Any transaction that increases or decreases the assets of the business must increase or decrease its liabilities by an identical amount.
You may be wondering exactly what is meant by saying that capital is an amount ‘ owed ’ by the business to its owner. How can the business ‘ owe ’ anything in this way? How has it incurred a debt? The answer is that when a business commences, it is common for the owners to ‘ invest ’ some of their private resources in the business. As the business oper-ates it generoper-ates its own resources in the form of profi ts, which technically belong to the owner. Some of the profi ts may remain in the business, while some may be withdrawn by the owner in the form of goods or cash. This withdrawal of profi ts in simple organisation structures such as sole traders is known as ‘ drawings ’ .
The equation that states that
AssetsLiabilitiesCapital
can thus be seen to demonstrate the relationships that exist within any business. The equa-tion is the basis of one of the most common accounting statements to be prepared – the statement of fi nancial position . It is worth noting here that the presentation of a statement of fi nancial position is based on the accounting equation.
2.3.1 The accounting equation in action
To see how this works, study the following example.
Example 2.A
On 31 March, Ahmed’s employment with Gigantic Stores Ltd came to an end. On 1 April, Ahmed sets up in business by himself, trading as ‘Ahmed’s Matches ’, and selling boxes of matches from a tray on a street corner.
Ahmed puts $100 into a bank account opened in the name of Ahmed’s Matches. He persuades a supplier of matches to let him have an initial inventory of 400 boxes, costing 5 p each, promising to pay for them next week. During his fi rst day of trading he sells 150 boxes at 12¢ each – $18 in all. Feeling well pleased, he takes $5 from the cash tin and treats himself to supper at the local café. He also writes a cheque for $5 to his supplier in part payment for the initial inventory of boxes. Show what happens to the accounting equation as each of these transactions takes place.
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THE FRAMEWORK OF FINANCIAL STATEMENTS
Solution
To begin with, the only asset of the business is $100 in the business bank account. Capital invested by Ahmed also amounts to $100 and the accounting equation looks like this:
Assets Liabilities Capital
Bank $100 0 Capital $100
The business then acquires matches worth $20 with a corresponding liability to the supplier. The accounting equation now looks like this: 5¢ each ($12.50). He also acquires a further asset in the process: cash in hand of $18. The accounting equa-tion now looks like this:
Assets Liabilities Capital
Bank $100 Payables $20 Original capital $100
Cash in hand $18 Profi t $10.50
Inventories $12.50
$130.50 $20 $110.50
Then Ahmed withdraws $5 from the business for his private use. This amount (referred to as drawings) reduces the sum owed to him by the business. The accounting equation now looks like this:
Assets Liabilities Capital
Bank $100 Payables $20 Original capital $100
Cash in hand $13 Profi t earned $10.50
Inventories $12.50 Less : drawings ($5)
$125.50 $20 $105.50
Finally, Ahmed makes a payment to his supplier, reducing the funds in the business bank account, and also reducing the amount of his liability. The accounting equation now looks like this:
Assets Liabilities Capital
Bank $95 Payables $15 Original capital $100
Cash in hand $13 Profi t earned $10.50
Inventories $12.50 Less : drawings ($5)
$120.50 $15 $105.50
Exercise 2.1
J Jones commenced business on 31 January 20X1, transferring $5,000 from her personal bank account into a business bank account.
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During the fi rst week of February 20X1 the following transactions occurred:
1 Feb. Bought motor van costing $800 paying by cheque
2 Feb. Bought goods on credit:
You are required to show the accounting equation at the end of each day’s transactions.
Solution
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THE FRAMEWORK OF FINANCIAL STATEMENTS