Chapter 2: The Accounting Equation
This chapter explains assets, liabilities and owner’s equity. It shows how the accounting equation works, why every transaction has two effects, how drawings affect owner’s equity, and how assets and liabilities appear in a statement of financial position.
Topic 1: Assets, liabilities and owner’s equity
These are the three building blocks of the accounting equation.
1. Assets, Liabilities and Owner’s Equity
Assets
Assets are resources of monetary value owned by the business or owed to the business.
Liabilities
Liabilities are amounts the business owes to other people or organisations.
Owner’s Equity
Owner’s equity, also called capital, is the amount owed by the business to its owner.
Examples of assets
- Cash
- Inventory
- Motor vehicles
- Machinery
- Property
- Trade receivables
Examples of liabilities
- Trade payables
- Bank overdraft
- Bank loan
Ali starts a business by putting $20,000 cash into it.
Assets = $20,000
Owner’s equity = $20,000
Topic 2: The accounting equation
The equation links what the business owns with the claims against those assets.
2. The Accounting Equation
The basic accounting equation is:
It can also be written as:
A business has:
Assets = $30,000
Liabilities = $8,000
Owner’s equity:
$30,000 − $8,000 = $22,000
So:
Assets $30,000 = Owner’s Equity $22,000 + Liabilities $8,000
Topic 3: Effect of transactions on the accounting equation
Every business transaction has a dual effect, which means at least two items are affected.
3. Effect of Transactions on the Accounting Equation
Example 1: Owner starts the business
Owner deposits $50,000 into the business bank account.
- Cash at bank increases by $50,000
- Owner’s equity increases by $50,000
Example 2: Buying an asset for cash
The business buys inventory for $5,000 by cheque.
Before purchase:
- Bank = $50,000
After purchase:
- Inventory = $5,000
- Bank = $45,000
Example 3: Buying an asset on credit
A motor vehicle costing $6,000 is bought on credit.
- Motor vehicle increases by $6,000
- Liability to the supplier increases by $6,000
If assets were originally $50,000:
Example 4: Paying a liability
The business owes a supplier $6,000 and pays $4,000 by cheque.
- Bank decreases by $4,000
- Liability decreases by $4,000
Topic 4: Drawings
Drawings are assets taken out of the business by the owner for personal use.
4. Drawings
Owner withdraws $2,000 cash for personal use.
- Cash decreases by $2,000
- Owner’s equity decreases by $2,000
$30,000 − $2,000 = $28,000
Topic 5: Types of assets and liabilities
Assets and liabilities are grouped according to how long they are expected to stay in the business or when they must be paid.
5. Types of Assets
Assets are divided into current assets and non-current assets.
Current Assets
Assets expected to be used, sold or converted into cash within about one year.
- Inventory
- Trade receivables
- Cash at bank
- Cash in hand
Trade receivables are customers who owe money to the business for goods or services bought on credit.
Non-current Assets
Assets bought for long-term use in the business, usually for more than one year.
- Machinery
- Motor vehicles
- Buildings
- Equipment
They are used to help the business earn revenue and are not normally bought for resale.
6. Types of Liabilities
Current Liabilities
Debts that must normally be paid within one year.
- Trade payables
- Bank overdraft
Trade payables are suppliers to whom the business owes money.
Non-current Liabilities
Debts that do not have to be repaid within the next 12 months.
- Long-term bank loan
Topic 6: Statement of financial position and double entry
The statement of financial position shows assets, liabilities and owner’s equity at a particular date. Double entry keeps the accounting equation balanced.
7. Statement of Financial Position
| Item | $ |
|---|---|
| Non-current assets | |
| Motor vehicle | 10,000 |
| Current assets | |
| Inventory | 5,000 |
| Cash | 8,000 |
| Total assets | 23,000 |
| Owner’s equity | 18,000 |
| Liabilities | |
| Trade payables | 5,000 |
| Total equity and liabilities | 23,000 |
8. Double Entry
Business buys machinery for $4,000 cash.
Two effects:
- Machinery increases by $4,000
- Cash decreases by $4,000
Topic 7: Key terms and remember box
These definitions and formulas summarise the most important ideas in Chapter 2.
Key Terms
Asset
Something of monetary value owned by or owed to the business.
Liability
An amount the business owes.
Owner’s equity
The owner's investment in the business.
Inventory
Goods bought for resale.
Trade receivables
Customers who owe the business money.
Trade payables
Suppliers to whom the business owes money.
Drawings
Assets withdrawn by the owner for personal use.
Statement of financial position
Shows assets, liabilities and owner’s equity at a particular date.
Assets = Owner’s Equity + Liabilities
Owner’s Equity = Assets − Liabilities
And:
Every transaction has two effects.