Chapter 2: The Accounting Equation PDF

# Chapter 2: The accounting equation ## Introduction ### Learning outcomes - Record and account for transactions and events resulting in income, expenses, assets, liabilities and capital in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards appl...

# Chapter 2: The accounting equation ## Introduction ### Learning outcomes - Record and account for transactions and events resulting in income, expenses, assets, liabilities and capital in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements - Identify the main components of a set of financial statements and specify their purpose and interrelationship ### Syllabus links The material in this chapter will be developed further in this exam, and then in Professional Level Financial Accounting and Reporting. ### Examination context Questions on the topics in this chapter will be set as multiple choice, multi-part multiple choice or multiple-response questions, some of which may involve calculations so that the correct answer can be selected. In the exam, you may be required to: - Identify and manipulate the accounting equation - Specify transactions affecting the elements of financial statements: assets, liabilities, capital, income and expenditure ## Learning topics 1. Assets, liabilities and the business entity concept 2. The accounting equation 3. Credit transactions 4. The statement of financial position 5. Preparing the statement of financial position 6. The statement of profit or loss ## Summary - Further question practice - Technical references - Self-test questions - Answers to Interactive questions - Answers to Self-test questions ## 1 Assets, liabilities and the business entity concept - Section overview - 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.' - Assets may be held for use in the long-term (non-current assets) or for the short term as trading assets (current assets). - A liability is a 'present obligation of the entity to transfer an economic resource as a result of past events.' - Liabilities may also be current (economic resources expected to be transferred in the next 12 months) or non-current (economic resources expected to be transferred in more than 12 months). - A business entity is a separate entity from its owners from an accounting point of view, whatever the legal position may be. ## 1.1 Assets and liabilities - Definition Asset: The Conceptual Framework states that 'an asset is a present economic resource controlled by the entity as a result of past event. An economic resource is a right that has the potential to produce economic benefits.' Assets are a key element of financial statements. Examples of assets: - Land and buildings: factories, office buildings, storage and distribution centres (warehouses) - Motor vehicles - Plant and machinery - Fixtures and fittings: computer equipment, office furniture and shelving - Software, capitalised development costs, licences quotas (known as intangible assets) - Cash: in a bank account or held as notes and coins - Inventory: goods held in store awaiting sale to customers, and raw materials and components held in store by a manufacturing business for use in production - Receivables: amounts owed by customers and others to the entity Some assets are expected to generate economic benefits over a number of years. An office building is occupied by administrative staff for years; similarly, a machine has a useful life of many years before it wears out. These are non-current assets. Other assets are expected to generate economic benefits in the short term. A newsagent, for example, has to sell his newspapers on the same day that he gets them. The quicker a business sells goods, the more profit it is likely to make, provided, of course, that the goods are sold at a higher price than what it cost the business to acquire them. Short-term assets are called current assets. - Definition Liability: The Conceptual Framework states that 'a liability is a present obligation of the entity to transfer an economic resource as a result of past events.' Liabilities are a key element of financial statements. Examples of liabilities: - A bank loan or overdraft: the liability is the amount eventually repaid to the bank. - Payables: amounts owed to suppliers for goods purchased but not yet paid for (purchases 'on credit'). For example, a boatbuilder buys some timber on credit from a timber merchant, so that the boatbuilder does not pay for the timber until some time after it has been delivered. Until the boatbuilder pays what he owes, the timber merchant is a creditor for the amount owed. - Taxation owed to the government. A business pays tax on its profits but there is a gap in time between when a business declares its profits (and becomes liable to pay tax) and the payment date. Liabilities for which economic resources are expected to be transferred in the next 12 months are current. Liabilities for which economic resources are expected to be transferred in more than 12 months are non-current. ## 1.2 The business as a separate entity You may have wondered whether an entity, such as a business, can own assets or have liabilities in its own name. There are two aspects to this question: the strict legal position and the convention adopted by accountants. Many businesses are carried on in the form of limited liability companies. The owners of a limited company are its shareholders, who may be few in number (as with a small, family-owned company)or very numerous (as with a large public company whose shares are listed on a stock exchange). The law recognises a company as a legal entity, quite separate from its owners. A company may, in its own name, acquire assets, incur debts, and enter into contracts. If a company's assets became insufficient to meet its liabilities, the company as a separate entity becomes 'insolvent'. However, the owners of the company are not usually required to pay the debts from their own private resources: the debts are not debts of the owners, but of the company. The case is different when a business is carried on by an individual (a sole trader). There is no legal separation between a sole trader and the business he/she runs. In most partnerships there is also no legal distinction. - **Context example: Sole trader** A sole trader starts business as a hairdresser, trading under the business name 'Quiff's Hair Salon'. The law recognises no distinction between the sole trader, the individual, and the business known as 'Quiff's Hair Salon'. Any debts of the business which cannot be met from business assets must be met from the sole trader's personal resources. However, in accounting any business is treated as a separate entity from its owner(s). This applies whether or not the business is recognised in law as a separate entity, ie, it applies whether the business is carried on by a company or by a sole trader. This is known as the business entity concept(or separate entity concept, or just entity concept). - **Definition** Business entity concept: A business is a separate entity from its owner. Although this may seem illogical and unrealistic you must try to appreciate it, as it is the basis of a fundamental rule of accounting, which is that the liabilities plus the equity of the business must always equal its assets. We will look at this rule in more detail later in this chapter, but a simple example now will clarify the idea of a business as a separate entity from its owners. - **Context example: The business as a separate entity** On 1 July 20X6, Charlie opened a flower stall. They had saved up CU2,500 and opened a business bank account with this amount. When the business commences, an accountant's picture can be drawn of what it owns and what it owes. The business begins by owning the cash that Charlie has put into it, CU2,500. The business is a separate entity in accounting terms. It has obtained assets, in this example cash, from Charlie. It therefore owes this amount of money to Charlie. If Charlie changed their mind and decided not to go into business, the business would be dissolved by the 'repayment' of cash to Charlie. - **Definition** Capital: The Conceptual Framework states that capital (which it calls equity in the context of a company, as we shall see in Chapter 11) is the 'residual interest in the assets of the entity after deducting all its liabilities.' Equity is a key element of financial statements. In simple terms, capital can be viewed as a measure of the owner's investment in the business. ## 2 The accounting equation - **Section overview** The basic accounting equation states that assets = capital + liabilities. Capital is the amount that the entity owes to its owners. ## 2.1 What is the accounting equation? - **Definition** Accounting equation: assets = capital + liabilities We will use an example to illustrate the accounting equation, ie, the rule that the assets of a business will at all times equal its liabilities plus capital. This is also known as the balance sheet equation. ## 2.2 Assets = capital + liabilities - **Context example: Assets = capital** Continuing from 'The business as a separate entity' example above, the business began by owning the cash that Charlie has put into it, CU2,500. The business is a separate entity in accounting terms and so it owes the money to Charlie as capital. In accounting, capital is an investment of money (funds) with the intention of earning a return. A business owner invests capital with the intention of earning profit. As long as that money is invested, accountants will treat the capital as money owed to the owner by the business. When Charlie sets up the business: - Cash at bank: CU 2,500 - Capital invested: CU 2,500 We can express Charlie's initial accounting equation as follows: For Charlie, as on 1 July 20X6: Assets: CU2,500 (cash at bank) = Capital: CU2,500 + Liabilities: CUO - **Context example: Different types of assets = capital** Charlie purchases a market stall for CU1,800. They also purchase some flowers from a trader in the wholesale market, at a cost of CU650. This leaves CU50 in cash, after paying for the stall and goods for resale, out of the original CU2,500. Charlie keeps CU30 in the bank and holds CU20 in small change for trading. They are now ready for their first day of market trading on 3 July 20X6. The assets and liabilities of the business have now altered, and on 3 July, before trading begins, the state of their business is as follows. Assets: - Stall: CU 1,800 - Flowers: CU 650 - Cash at bank: CU 30 - Cash in hand: CU 20 = Capital: CU 2,500 + Liabilities: CUO The stall and the flowers are physical items, but they must be given a money value. This money value is usually what they cost the business (called historical cost in accounting terms). ## 2.3 Where do profits/losses fit into the accounting equation? - **Context example: Assets = capital + profit** On 3 July Charlie sells all the flowers for CU900 cash. Since Charlie has sold goods costing CU650 to earn income of CU900, we can say that they have earned a profit of CU250 on the day's trading. Profits are added to the owner's capital. In this case, the CU250 belongs to Charlie. However, so long as the business retains the profits and does not pay anything out to its owner, the retained profits are accounted for as an addition to the owner's (Charlie) capital. Assets: - Stall: CU 1,800 - Flowers: CU 0 = Capital CU - Original investment: CU 2,500 + Liabilities CU - 0 Assets: - Cash in hand and at bank (30+20+ 900): CU 950 = Capital: CU - Retained profit (900-650): CU 250 + Liabilities CU - 0 - 2,750 = 2,750 We can re-arrange the accounting equation to help us to calculate the capital balance. Assets - liabilities (net assets) = Capital At the beginning and end of 3 July 20X6, Charlie's financial position was as follows: - (a) At the beginning of the day: - Net assets: CU(2,500-0) = CU2,500 - Capital: CU2,500 - (b) At the end of the day: - Net assets: CU(2,750-0) = CU2,750 - Capital CU2,750 There has been an increase of CU250 in net assets, which is the amount of profit earned during the day. - **Definitions** - Profit: The excess of income over expenses. - Loss: The excess of expenses over income. - Income: Income is 'increases in assets or decreases in liabilities that result in increases in equity(capital), other than those relating to contributions from holders of equity claims.' (Conceptual Framework) It can include both revenue and gains. - Expenses: Expenses are 'decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims.' (Conceptual Framework) Thus: - Profits are added to owner's capital. - Losses are deducted from owner's capital. Note that the Conceptual Framework identifies income and expenses, and assets, liabilities and equity, as the elements of financial statements. Each element represents a class of transactions or other events that are grouped together according to their economic characteristics. ## 2.4 Appropriation of profits: sole trader drawings The owner of a sole tradership does not get paid a wage; they 'draw out' or appropriate some of their capital as drawings. - **Definition** Drawings: Money and goods taken out of a business by its owner. - **Context example: Appropriations of profit** Business owners, like everyone else, need income for living expenses. Charlie therefore decides to take CU180 from the business in 'wages'. The payment of CU180 is regarded by Charlie as a fair reward for their day's work and they might think of the sum as 'wages'. However, the CU180 Charlie draws is not an expense to be deducted in arriving at the figure of net profit because any amounts paid by a business to its owner are treated by accountants as withdrawals or appropriations of profit and not as expenses incurred by the business. In the case of Charlie's business, the true position is: - Net profit earned by the business: CU 250 - Less profit withdrawn by Charlie: CU (180) - Net profit retained in the business: CU 70 Profits are capital as long as they are retained in the business. Once they are appropriated, the business suffers a reduction in capital. The withdrawals of profit are taken in cash, and so the business loses CU180 of its cash assets. After the withdrawal has been made, the accounting equation would be restated. - (a) Assets: - Stall: CU 1,800 - Flowers: CU 0 - Cash (950-180): CU 770 = Capital: - CU 2,570 + Liabilities: - CU 0 - (b) Alternatively: - Net assets = Capital: CU(2,570-0) = CU2,570 The increase in net assets since trading operations began is now only CU(2,570 - 2,500) = CU70, which is the amount of the retained profits. - **Context example: Assets = capital** On 10 July Charlie purchases flowers for cash, at a cost of CU740. Charlie decides to employ their cousin for a wage of CU40 for the day. After the purchase of the goods for CU740 the accounting equation is: Assets: - Stall: CU 1,800 - Flowers: CU 740 - Cash (770-740): CU 30 = Capital CU - 2,570 + Liabilities CU - 0 On 10 July, all the flowers were sold for CU1,100 cash, and Charlie's cousin is paid CU40. The profit for the day is calculated as follows: - Sales: CU 1,100 - Less cost of goods sold: CU 740 - Wages: CU 40 - Profit: CU 320 Assets: - Stall: CU 1,800 - Flowers: CU 0 - Cash (30+1,100-40): CU 1,090 = Capital: CU - At beginning of 10 July: CU 2,570 - Profits earned on 10 July: 320 + Liabilities: - CU 0 - 2,890 = 2,890 + 320 = 0 Charlie has also decided to withdraw CU200 in cash, therefore retained profits will be only CU(320 – 200) = CU120. Assets: - Stall: CU 1,800 - Flowers: CU 0 - Cash (1,090-200): CU 890 = Capital: CU - At beginning of 10 July: CU 2,570 - Retained profits for 10 July: 120 + Liabilities: - CU 0 = 2,690 = 2,690 **Interactive question 1: Capital** Fill in the missing words: Capital = _____ less _____ _See Answer at the end of this chapter._ ## 3 Credit transactions - **Section overview** - A creditor is any party to whom the entity owes money. - A trade payable is a creditor which has arisen following a purchase on credit by the entity. - A trade payable is a liability of the entity. - A debtor is any party who owes money to the entity. - A trade receivable is a debtor which has arisen following a sale on credit by the entity. - A trade receivable is an asset of the entity. - The matching or accruals concept requires that income is matched with the expenses incurred in earning it. This concept is the reason why we account for credit transactions before they are realised in the form of cash. ## 3.1 Trade payables - **Definition** Creditor: A party (normally an individual, another business or a financial institution) to whom a business owes money. A trade creditor is a party to whom a business owes money for trading debts. In the accounts of a business, debts still outstanding which arise from the purchase from suppliers of materials, components or goods for resale are called trade payables. A business does not always pay immediately for goods or services it buys. It is common business practice to make credit purchases, with a promise to pay within 30/60/90 days, of the date of the bill or 'invoice' for the goods. For example, Acorn buys goods costing CU2,000 on credit from Branch, Branch sends Acorn an invoice for CU2,000, dated 1 March, with credit terms that payment must be made within 30 days. If Acorn then delays payment until 31 March, Branch will be a creditor of Acorn between 1 and 31 March for CU2,000. From Acorn's point of view, the amount owed to Branch is a trade payable. A trade payable is a liability of a business. When the debt is finally paid, the trade payable'disappears' as a liability and the balance of cash at bank and in-hand decreases. - **Definition** Trade payables: The amounts due to credit suppliers. ## 3.2 Trade receivables - **Definition** Debtor: A party who owes money to the business. A trade debtor is a party from whom a business is owed money for trading debts. Suppose that Cedar sells goods on credit to Diggy for CU6,000 on terms that the debt must be settled within two months of the invoice date, 1 October. Diggy will be a debtor of Cedar for CU6,000 from 1 October until the date payment is made. In the accounts of the business, amounts owed by debtors are called trade receivables. A trade receivable is an asset of a business. When the debt is finally paid, the receivable 'disappears'as an asset, to be replaced by 'cash at bank and in hand'. - **Definition** Trade receivables: The amounts owed by credit customers. - **Worked example: Assets = capital + liabilities** Look at the consequences of the following transactions in the week to 17 July 20X6. (See Worked example: Assets = capital for the situation as at the end of 10 July.) (1) Charlie realises more money is needed for the business and so makes the following arrangements. (a) Invests a further CU250 of their own capital. (b) Persuades her uncle to lend the business CU500. Charlie's uncle agrees that the loan can be repaid at a later date but, in the meantime, an interest of CU5 per week should be paid on the loan. They both agree that it will probably be quite a long time before the loan is eventually repaid in full. (2) Charlie decides to buy a van to pick up flowers from the supplier and bring them to the market stall. A car dealer agrees to sell a van on credit for CU700. Charlie agrees to pay for the van after 30 days' trial use. (3) During the week, Charlie pays CU300 in cash to purchase garden furniture for sale to a customer. The furniture is delivered straight to the customer which will pay CU350 at the end of the month. (4) Charlie buys flowers costing CU800. Of these purchases CU750 are paid in cash, with the remaining CU50 on seven days' credit. Charlie decides to use their cousin's services again, at an agreed wage of CU40 for the day. (5) On 17 July, Charlie sells all the goods, for CU1,250 (cash). Charlie decides to withdraw CU240 for their week's work. Charlie also pays their cousin CU40 in cash and decides to make the interest payment to their uncle soon. (6) There are no van expenses for the week. - **Solution** Deal with transactions one at a time in chronological order. (In practice, it is possible to do one set of calculations which combines all transactions.) (1) The addition of Charlie's extra capital and the loan received An investment analyst might call the loan a capital investment, on the grounds that it will probably before the long term. However, Charlie's uncle is not the owner of the business simply as a result of providing the loan. To the business, Charlie's uncle is a long-term creditor, and it is appropriate to define the loan provided as a liability and not business capital. The accounting equation after CU(250 + 500) = CU750 cash is put into the business will be: Assets: - Stall: CU 1,800 - Goods: CU 0 - Cash (890+750): CU 1,640 = Capital: CU - As at end of 10 July: CU 2,690 - Additional capital: CU 250 + Liabilities: CU - Loan: CU 500 - 3,440 = 2,940 + 500 (2) The purchase of the van (cost CU700) on credit Assets: - Stall: CU 1,800 - Van: CU 700 - Cash: CU 1,640 = Capital CU - As at end of 10 July: CU 2,690 - Additional capital: CU 250 + Liabilities CU - Loan: CU 500 - Payables: CU 700 - 4,140 = 2,940 + 1,200 (3) The sale of goods to Uncle on credit CU350 which cost the business CU300 (cash paid) Assets: - Stall: CU 1,800 - Van: CU 700 - Receivable: CU 350 - Cash (1,640-300): CU 1,340 = Capital CU - As at end of 10 July: CU 2,690 - Additional capital: CU 250 - Profit on sale (350- 300): CU 50 + Liabilities CU - Loan: CU 500 - Payables: CU 700 - 4,190 = 2,990 + 1,200 (4) After the purchase of goods for the weekly market CU750 paid in cash and CU50 of purchases on credit) Assets: - Stall: CU 1,800 - Van: CU 700 - Goods (750+50): CU 800 - Receivable: CU 350 - Cash (1,340-750): CU 590 = Capital CU - As at end of 10 July: CU 2,690 - Additional capital: CU 250 - Profit on sale: CU 50 + Liabilities CU - Loan: CU 500 - Payables (van): CU 700 - Payables (goods): CU 50 - 4,240 = 2,990 + 1,250 (5) After market trading on 17 July Goods costing CU800 earned income of CU1,250 in cash. Charlie's cousin's wages were CU40 (paid), the loan interest charge is CU5 (not paid yet) and drawings were CU240 (paid). The profit for 17 July may be calculated as follows, taking the full CU5 of interest as a cost on that day. - Sales: CU 1,250 - Cost of goods sold: CU 800 - Wages: CU 40 - Interest: CU 5 - Profit earned on market trading on 17 July: CU (845) - Profit on sale of goods to Uncle: CU 50 - Profit for the week: CU 455 - Drawings: CU (240) - Retained profit: CU 215 Assets: - Stall: CU 1,800 - Van: CU 700 - Goods (800- 800): CU 0 - Receivable: CU 350 - Cash (590 + 1,250-40- 240): CU 1,560 = Capital: CU - As at end of 10 July: CU 2,690 - Additional capital: CU 250 - Profits retained: CU 215 + Liabilities: CU - Loan: CU 500 - Payables (van): CU 700 - Payables (goods): CU 50 - Payables (interest): CU 5 - 4,410 = 3,155 + 1,255 ## 3.3 Accruals concept The accruals (or matching) concept requires that income earned is matched with the expenses incurred in earning it. In Charlie's case, we have 'matched' the income earned with the expenses incurred in earning it. So in part (e), we included all the costs of the goods sold of CU800, even though CU50 had not yet been paid in cash. Also, the interest of CU5 was deducted from income even though it had not yet been paid. **Interactive question 2: The accounting equation** How would each of these transactions affect the accounting equation in terms of increase or decrease in asset, capital or liability? (1) Purchasing CU800 worth of goods on credit (2) Paying the telephone bill CU25 (3) Selling CU450 worth of goods for CU650 (4) Paying CU800 to a supplier _See Answer at the end of this chapter._ We shall look now at how the business entity concept and accruals concept together result in the statement of financial position. ## 4 The statement of financial position - **Section overview** - The statement of financial position shows the entity's financial position at a particular moment intime. - The statement of financial position represents the accounting equation: assets are in one half and capital and liabilities in the other. - The more detailed accounting equation, represented in the IAS 1 format for the statement of financial position, states that non-current assets + current assets = capital + profit - losses - drawings + non-current liabilities + current liabilities. - Net assets = assets - liabilities, therefore net assets = capital. - A non-current asset is acquired for long term use in the business, with a view to earning profits from its use, either directly or indirectly. - Non-current assets may be tangible (with a physical reality) or intangible. - Current assets are either cash or items which are held by the entity to be turned into cash shortly. - Capital comprises opening capital + capital introduced + profits - losses - drawings of capital/profits taken by the owners. - Non-current liabilities are payable after one year, such as secured loans. - Current liabilities are payable within one year, such as trade payables and bank overdrafts. ## 4.1 What is a statement of financial position? The business's statement of financial position shows its liabilities, capital and assets at a point in time. It is a 'financial snapshot' of the position of the business at the end of the reporting period to which the financial statements relate. A statement of financial position is very similar to the accounting equation. In fact, the only differences between a statement of financial position and an accounting equation are: - the manner or format in which the liabilities and assets are presented - the extra detail which is usually contained in a statement of financial position A statement of financial position is divided into two halves, and is presented in either of the following ways: - capital and liabilities in one half and assets in the other (the IAS 1 format that we adopt in this Workbook) - capital in one half and net assets in the other (the GAAP format for the balance sheet) - **Definition** Net assets: Assets less liabilities In this Workbook we will follow the assets = capital + liabilities format given by IAS 1, Presentation of Financial Statements. Name of business: Statement of financial position as at (date) Assets (item by item): CI Capital: X Liabilities: X The total amount in one half of the statement of financial position equals the total amount in theother half. Since each half of the statement of financial position has an equal amount, one side balances the other. Assets, capital and liabilities are usually shown in some detail in a statement of financial position. The following paragraphs describe the sort of detail we might expect to find. ## 4.2 Assets The statement of financial position distinguishes between non-current assets and current assets (again as required by IAS 1). Non-current assets are acquired for long-term use within the business. They are normally carried at cost less accumulated depreciation. Current assets are expected to be converted into cash within one year. ## 4.2.1 Non-current assets - **Definition** Non-current assets: Assets acquired for continuing use within the business, with a view to earning income or making profits from their use, either directly or indirectly, over more than one reporting period. Non-current assets in the statement of financial position usually comprise: - property, plant and equipment (ie, 'tangible' assets) - intangible assets such as patents and licences - long-term investments A non-current asset is not acquired for sale to a customer. - In a manufacturing industry, a production machine is a non-current asset, because it makes goods which are then sold. - In a service industry, equipment used by employees giving service to customers is a non-current asset (eg, the equipment used in a garage, or furniture in a hotel). - Less obviously, factory premises, office furniture, computer equipment, company cars, delivery vans or pallets in a warehouse are all non-current assets. To be classed as a non-current asset in the business's statement of financial position, an item must satisfy two further conditions: - It must be used by the business. For example, the owner's own house would not normally appear on the business statement of financial position. - The asset must have a 'life' in use of more than one reporting period or year. A tangible non-current asset is a physical asset that can be touched. All of the examples of non- current assets mentioned above are 'tangible' assets. They are often referred to as property, plant and equipment. Intangible non-current assets do not have a physical existence; they cannot be 'touched'. Examples are, a patent, which protects an idea and, a licence, which permits the holder to operate in a certain area or use an asset in a particular way. An investment can also be a non-current asset. Company A might invest in another company, B, by purchasing some of B's shares. These investments will earn income for A in the form of dividends paid out by B. If the investments are purchased by A with a view to holding on to them for more than one year, they would be classified as non-current assets of A. In this chapter, we shall restrict our attention to tangible non-current assets. ## 4.2.2 Non-current assets and depreciation Non-current assets are held and used by a business for a number of years, but they wear out or lose their usefulness in the course of time. Every tangible non-current asset has a limited life, known as the 'useful life' to the business. This is not necessarily the same as the total life of the asset. For example, a well-maintained car might expect to have a total life of ten years but, if a business plans to replace the car after five years, its useful life to the business is only five years. The exception to having a useful life is freehold land, although this too can be exhausted if it is used by extractive industries (eg, mining). The financial statements of a business reflect that the cost of a non-current asset is gradually consumed as the asset is used over its useful life. This is done by gradually 'writing off' the asset's cost in the statement of profit or loss over several reporting periods. For example, in the case of a machine costing CU1,000 and expected to wear out after 10 years, it is appropriate to reduce the value in the statement of financial position by CU100 each year. This process is known as depreciation. If a statement of financial position were drawn up four years after the asset was purchased, the amount of depreciation accumulated over four years would be 4 × CU100 = CU400. The machine would then appear in the statement of financial position as follows. - Machine at original cost: CU 1,000 - Less accumulated depreciation: CU (400) - Carrying amount*: CU 600 *ie, the value of the asset in the financial accounts, net of accumulated depreciation. After 10 years the asset would be fully depreciated and would appear in the statement of financial position with a carrying amount of zero. The amount that is written off over time does not have to be the full cost of the asset if it is expected to have a resale - or 'residual' - value at the end of its useful life. **Interactive question 3: Residual value** Suppose a business buys a car for CU10,000. It expects to keep the car for three years and then to sell it for CU3,400. _Requirement_ What amount of depreciation should be accounted for in each year of the car's useful life? _See Answer at the end of this chapter._ We shall study non-current assets in detail in Chapter 10. ## 4.2.3 Current assets Current assets take one of the following forms: • Items owned by the business with the intention of turning them into cash in a short time, usually within one year (see the worked example below).