EE

Accounting Equation Notes

The Accounting Equation

  • The accounting equation puts the statement of financial position into equation form.
  • Basic formula: Assets = Capital + Liabilities
    • Assets appear at the top of the financial position.
    • Capital plus liabilities are at the bottom.
  • Alternative form: Assets = Capital + Profit - Drawings + Liabilities
    • Capital + Profit - Drawings = Owner's interest (or Proprietor's interest)
  • Rearranging the equation:
    • Assets - Liabilities = Capital + Profit - Drawings
    • Moving terms across the equals sign changes their sign.
  • Assets - Liabilities = Net Assets
    • Therefore, Net Assets = Proprietor's Interest
  • Understanding the components is crucial, especially when liabilities are moved to the asset side.

Example: Liza's Business

  • Liza invests 2,500 of her own money to start a business.
    • This investment is called capital.
    • Capital: Investment of money by the owner with the goal of earning profit.
  • Accounting equation: Assets = Capital
    • Cash (Asset) \$2,500 = Capital \$2,500 (No liabilities initially)
  • As the business grows, the accounting equation changes with each transaction.

Transactions and the Accounting Equation

  • Liza's transactions:
    • Buys a store for \$1,800 (Asset).
    • Buys flowers and plants for \$6.50 (Inventory).
    • Takes out a bank loan (Liability).
  • Updated accounting equation:
    • Assets = Capital + Liabilities
    • Assets: Store (\$1,800) + Inventory (\$6.50) + Cash (\$5.50)
    • Capital: same
  • Cash Calculation: Initial cash (\$2,500) - Store (\$1,800) - Flowers (\$6.50) = Cash (\$5.50)

Drawings and Profit

  • Drawings: Money taken out of the business by the owner.
    • When Liza pays herself a wage, it's considered drawings, not wages.
  • Extended accounting equation:
    • Opening Capital + Profit - Drawings = Closing Capital
  • Liza sells flowers for \$1,000 and withdraws \$300 for personal use (drawings).
  • Cash Flow Changes:
    • Initial Cash: \$5.50
    • Sales: \$1,000
    • Drawings: \$300
    • New cash balance(bank): \$12.50
  • Profit Calculation:
    • Sales: \$1,000
    • Cost of Flowers: \$6.50
    • Profit: \1,000 - 6.50 = 3.50

Balancing and Problem Solving

  • The accounting equation must always balance.
  • Profit is crucial for balancing the equation.
  • Exam questions often require finding the profit or assets figure by rearranging the equation.

Activity 6: Identifying the Correct Equation

  • The correct accounting equation from the options is:
    • Assets - Liabilities = Opening Capital + Profit - Drawings

Activity 7: Business Equation

  • Business equation focuses on current period movements.
  • Formula: Change in Net Assets = Change in Capital + Profit - Drawings
  • Given:
    • Profit for 2007: \$72,500
    • New Capital injected: \$8,000
    • Withdrawals (drawings): \$2,200
    • Net Assets at the beginning of 2007: \$101,700
  • Calculation:
    • Change in Net Assets = \$8,000 + 72,500 - 2,200 = 78,300
  • Closing Net Assets = Opening Net Assets + Change in Net Assets
    • Closing Net Assets = \$101,700 + 78,300