Accounting Equation: Assets, Liabilities and Equity

The Accounting Equation

• The accounting equation is Assets = Liabilities + Equity/Capital
• Assets are what a company owns or controls and represent the resources of the company.
• Liabilities are what a company owes to others.
• Equity/Capital is the owner's stake in the company.
• Resources: Assets are what the company currently has
• Resources: Liabilities and Equity, represent who supplied assets
• The two sides of the accounting equation always have the same totals.
• Simplified accounting equation: Assets = Capital if no one else as provided assets to the company.
• Simplified accounting equation with Liabilities: Assets – Liabilities = Capital

Assets

• An asset is a present economic resource controlled by the entity as a result of past events.
• An economic resource is a right that has the potential to produce economic benefits

Classification Of Assets

• Current assets examples: Inventory (stock), Trade receivables (debtors), Cash at bank, Cash in hand, Prepaid expenses.
• Current assets are expected to change or be used up within a year.
• Non-current assets examples are: Land and buildings, Fixtures and fittings, Machinery, Motor vehicles, Brand name, Copyright.
• Non-current assets are for long term use in business.

Liabilities

• A liability is a present obligation of the entity to transfer an economic resource as a result of past events.
• Amount owed by the business for assets supplied to a business or expenses incurred not yet paid.

Classification of Liabilities

• Examples of current liabilities: Trade payables (creditors), Rent payable, Salaries payable, Bank overdraft, Unearned revenue.
• Current liabilities are expected to be settled within a year.
• Examples of non-current liabilities: Bank loan, Mortgage, Bond/debenture, Lease, Hire purchase, Pension benefit obligations.
• Non-current liabilities are settled over a period longer than a year.

Equity

• Equity is the residual interest in the assets of the entity after deducting all its liabilities.
• Accounting equation for equity: Equity = Assets - Liabilities
• Equity is called the net assets or net worth
• Equity of a sole proprietorship or partnership is called capital
• Equity of a company usually consists of share capital, retained earnings and other reserves

Capital

• Capital is the total of resources invested and left in a business by its owner.
• Accounting equation for capital: Capital = Assets - Liabilities
• Capital is often synonymous with owner's equity
• Increases to Capital: Owner's investment and Income
• Decreases to Capital: Owner's drawings, Expenses, Profit or loss.

Income

• Includes revenue & gains that were not invested by the owner
• Examples of this are: Sales revenue, Interests revenue, Rent revenue, Gain on disposal of shares and Gain on disposal of properties

Expenses

• Includes the cost of assets and services that were used up in obtaining the income
• Losses that were not distributions to the owner
• Examples include: Salaries / wages, Interest, rent, Insurance, Audit fees, Training, Maintenance, Printing & stationery, and Loss on disposal of motor vehicles.

Profit or Loss

• Profit occurs when income is greater than expenses
• Loss occurs when expenses are greater than income

Drawings

• Drawings refer to amounts withdrawn from the business by the Owner for private use
• Drawings of money reduce cash or bank balances.
• Drawings of goods reduce purchases or inventory
• Normal practice is to have a separate drawings account & deduct the total of the drawings account from capital at the end of each period.

Transaction Analysis

• Every transaction affects at least two items in the accounting equation
• Transactions changes two assets by reducing one and increasing the other
• The equation must always remain equal: Assets = Liabilities + Capital

Examples of Transactions

• Owner pays capital into the bank
• Buy inventory by cheque (cash basis)
• Buy inventory on time (credit basis)
• Sell inventory on time (credit basis)
• Receive cheque for selling inventory (cash basis)
• Pay creditor by cheque
• Receive a cheque from debtor
• Owner takes money out of the business bank account for own use (drawings)
• Owner pays creditor from private money outside the firm