The Accounting Equation (Cambridge (CIE) A Level Accounting): Revision Note
Exam code: 9706
Assets, liabilities & capital
What are assets?
Assets are things owned by the business
Premises, inventory, motor vehicles, money in the bank, etc
Assets also include amounts that are owed to the business by other people or businesses
Money owed to the business by credit customers
These are called trade receivables
Current assets are short-term assets that the business intends to liquidate within a year
Trade receivables, inventory, money in the bank, etc
Non-current assets are long-term assets that the business intends to own for more than a year and they are not easily liquated
Premises, motor vehicles, etc
What are liabilities?
Liabilities are the amounts that the business owes to other people or businesses
Bank loans, bank overdraft, etc
Money owed to credit suppliers by the business
These are called trade payables
Current liabilities are short-term liabilities which the business intends to pay within a year
Trade payables, bank overdraft, etc
Non-current liabilities are long-term liabilities which the business intends to take longer than a year to repay
Bank loans, etc
What is capital or owner’s equity?
Capital is any resource provided by the owner to start up the business or keep it going
This is sometimes referred to as owner’s equity
Capital is often in the form of money
However, it may also consist of other assets
Such as buildings, furniture, equipment, motor vehicles, goods, etc
The owner invests capital into their business
Technically the business owes these assets to the owner
If a business makes a profit then its capital increases
If a business makes a loss then its capital decreases
What are drawings?
Drawings refer to when an owner takes assets from the business for personal use
This could be money, goods, motor vehicles, etc
If the owner takes drawings from the business then the capital decreases
The accounting equation
What is the formula for the accounting equation?
The formula for the accounting equation is: Assets = Liabilities + Capital
The equation states that the assets of a business are always equal to the liabilities and capital of the business
You can rearrange the equation so that you can find one of the three values if the other two are known
Liabilities = Assets - Capital
Capital = Assets - Liabilities
Examiner Tips and Tricks
You may be given examples of assets and liabilities and asked to calculate the missing figure for capital.
Worked Example
The assets and liabilities are listed below for a business.
$ | |
Premises | 8 500 |
Equipment | 7 000 |
Inventory | 1 000 |
Trade receivables | 5 000 |
Trade payables | 4 500 |
Bank overdraft | 1 200 |
Calculate the capital of the business.
Answer:
STEP 1
Calculate the total assets:
$ | |
Premises | 8 500 |
Equipment | 7 000 |
Inventory | 1 000 |
Trade receivables | 5 000 |
Total assets | 21 500 |
STEP 2
Calculate the total liabilities:
$ | |
Trade payables | 4 500 |
Bank overdraft | 1 200 |
Total liabilities | 5 700 |
STEP 3
Apply the formula Capital = Assets - Liabilities
$21 500 - $5 700 = $15 800
Why is the accounting equation important?
The accounting equation may be shown in the form of a statement of financial position
The statement of financial position will be affected every time the business makes changes to the assets, liabilities and capital
Every single transaction will result in at least two changes which balance out
Both sides of the equation could increase by the same amount
Both sides of the equation could decrease by the same amount
Both sides of the equation could stay the same
Case Study
Hannah is the owner of a business. Some of her transactions are listed below. After each transaction, the accounting equation still balances.
Transaction | Effects on assets | Effects on liabilities or capital |
|---|---|---|
A credit customer, Peter, pays the amount owed to Hannah by cheque for $1 120 | Assets increase by $1 120 because the money in the bank increases Assets decrease by $1 120 because the amount owed by Peter decreases Overall no change to assets | No change in liabilities or capital |
Hannah pays the amount owed to a credit supplier, Rizwan, by cheque for $4 200 | Assets decrease by $4 200 because the money in the bank decreases | Liabilities decrease by $4 200 because the amount owed to Rizwan decreases |
Hannah buys additional fixtures and fittings for $5 500 on credit from FixFit Ltd | Assets increase by $5 500 because the value of Hannah's assets increases | Liabilities increase by $5 500 because the amount owed to FixFit Ltd increases |
Hannah takes goods worth $500 from the business for personal use | Assets decrease by $500 because the amount of inventory decreases | Capital decreases by $500 because Hannah takes drawings from the business |
Hannah transfers $1 000 from her personal bank account into the business bank account | Assets increase by $1 000 because the money in the bank increases | Capital increases by $1 000 because Hannah invests $1 000 into the business |
Hannah makes $20 profit by selling goods which cost $30 for $50 cash | Assets increase by $50 because the amount of cash increases Assets decrease by $30 because the amount of inventory decreases Overall assets increase by $20 | Capital increases by $20 because a profit has been made |
Worked Example
A business pays one of its trade payables by cheque. Identify the effects on the business' assets and liabilities.
| Effect on assets | Effect on liabilities |
A | Reduce bank | Reduce trade payables |
B | Increase bank | Increase trade payables |
C | Reduce trade payables | Reduce bank |
D | Increase trade payables | Increase bank |
Answer:
Money in the bank is an asset and trade payables is a liability. A payment made by cheque would reduce the money in the bank, therefore reducing the asset. Trade payable is a liability. The business debt would be reduced when payment is made.
The answer is A.
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