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The Accounting Equation

Subject: Accounting
Topic: 2
Cambridge Code: 0452 / 0985 / 7707

Definition​

The Accounting Equation is the fundamental principle underlying all accounting:

Assets=Liabilities+Capital\text{Assets} = \text{Liabilities} + \text{Capital}

Or:

A=L+CA = L + C

This equation must always balance - it is the basis of double-entry bookkeeping.

Assets​

Assets - Resources and property owned by the business with monetary value

Types of Assets​

Fixed Assets (Non-Current Assets)​

Assets intended for long-term use in business

Examples:

  • Land and buildings
  • Machinery and equipment
  • Vehicles
  • Furniture and fixtures
  • Computers
  • Patents and trademarks

Characteristics:

  • Held for more than one year
  • Used in running the business
  • Not intended for resale
  • Depreciates over time
  • Listed as non-current assets on balance sheet

Current Assets​

Assets intended for conversion to cash or use within one year

Examples:

  • Cash
  • Bank account
  • Petty cash
  • Inventory (stock)
  • Accounts receivable (debtors)
  • Prepaid expenses
  • Short-term investments

Characteristics:

  • Held for less than one year
  • More liquid (easily convertible to cash)
  • Used for day-to-day operations
  • Listed as current assets on balance sheet

Liabilities​

Liabilities - Amounts owed by the business to others

Types of Liabilities​

Long-Term Liabilities (Non-Current Liabilities)​

Debts due after more than one year

Examples:

  • Long-term bank loans
  • Mortgages
  • Bonds payable
  • Deferred tax

Short-Term Liabilities (Current Liabilities)​

Debts due within one year

Examples:

  • Accounts payable (creditors)
  • Short-term bank loans
  • Interest payable
  • Wages payable
  • Overdraft
  • Tax payable

Capital (Owner's Equity)​

Capital - The owner's investment in the business and accumulated profits

Components of Capital​

Opening Capital - Amount invested by owner initially

Add: Profit - Net profit earned during period

Less: Drawings - Cash/goods withdrawn by owner for personal use

Closing Capital - Opening capital + profit - drawings

Closing Capital=Opening Capital+Profit−Drawings\text{Closing Capital} = \text{Opening Capital} + \text{Profit} - \text{Drawings}

The Equation in Practice​

Verification​

In every accounting period: Total Assets=Total Liabilities+Total Capital\text{Total Assets} = \text{Total Liabilities} + \text{Total Capital}

Balance Sheet Presentation​

Balance Sheet as at [Date]

ASSETS
Non-Current AssetsXX
Current AssetsXX
Total AssetsXX
LIABILITIES
Non-Current LiabilitiesXX
Current LiabilitiesXX
Total LiabilitiesXX
CAPITALXX
Total Capital & LiabilitiesXX

The Equation After Transactions​

When transactions occur, both sides of the equation change but remain balanced.

Example Transactions​

Transaction 1: Owner invests $10,000 cash

  • Assets increase (cash $10,000)
  • Capital increases ($10,000)
  • Equation: 10,000=10,000 = 0 + $10,000 ✓

Transaction 2: Buy equipment for $3,000 cash

  • Asset (cash) decreases by $3,000
  • Asset (equipment) increases by $3,000
  • Equation still: 10,000=10,000 = 0 + $10,000 ✓

Transaction 3: Buy inventory on credit for $2,000

  • Asset (inventory) increases by $2,000
  • Liability (payable) increases by $2,000
  • Equation: 12,000=12,000 = 2,000 + $10,000 ✓

Transaction 4: Sell goods for 1,500cash(cost1,500 cash (cost 1,000)

  • Asset (cash) increases by $1,500
  • Asset (inventory) decreases by $1,000
  • Capital increases (profit $500)
  • Equation: 11,500=11,500 = 2,000 + $10,500 ✓

Worked Examples​

Example 1: Calculate Missing Figure​

A business has:

  • Total Assets = $50,000
  • Total Liabilities = $20,000
  • Capital = ?

Capital=Assets−Liabilities=50,000−20,000=30,000\text{Capital} = \text{Assets} - \text{Liabilities} = 50,000 - 20,000 = 30,000

Example 2: Effect of Transactions​

Starting position:

  • Assets $40,000
  • Liabilities $15,000
  • Capital $25,000

Transaction: Receives loan of $10,000

  • Assets increase to $50,000
  • Liabilities increase to $25,000
  • Capital remains $25,000
  • Check: 50,000=50,000 = 25,000 + $25,000 ✓

Example 3: Calculate Net Profit​

Opening position:

  • Assets $30,000
  • Liabilities $10,000
  • Capital $20,000

Closing position:

  • Assets $50,000
  • Liabilities $12,000
  • Capital = ?

Capital=50,000−12,000=38,000\text{Capital} = 50,000 - 12,000 = 38,000

Change in capital = 38,000−38,000 - 20,000 = $18,000

If drawings were $2,000: Profit=18,000+2,000=20,000\text{Profit} = 18,000 + 2,000 = 20,000

Key Points to Remember​

  1. Assets = Liabilities + Capital (must always balance)
  2. Assets are resources owned by business
  3. Liabilities are amounts owed
  4. Capital is owner's investment and accumulated profits
  5. Every transaction maintains the equation
  6. Fixed assets held long-term; current assets held short-term
  7. Balance sheet shows the equation at a point in time

Practice Questions​

  1. Explain the accounting equation and why it must always balance.
  2. Classify these items as assets, liabilities, or capital:
    • Cash in bank
    • Amount owed to suppliers
    • Owner's investment
    • Machinery
    • Inventory
    • Bank loan
  3. A business has assets of 60,000andliabilitiesof60,000 and liabilities of 25,000. What is the capital?
  4. Opening capital was 30,000.Duringtheyear,profitwas30,000. During the year, profit was 8,000 and drawings were $3,000. Calculate closing capital.

Revision Tips​

  • Remember the equation must always balance
  • Understand the difference between fixed and current assets
  • Know how capital changes with profit and drawings
  • Practice calculating missing figures
  • Use the equation to check work