Accounting Equation

Chapter-3

Chapter

ACCOUNTING EQUATION

CHAPTER CONTENTS
Introduction Basic Terms and Definitions Basic Equation Business Equation Practice Questions
Answer Bank

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INTRODUCTION The entire accounting system rests on one basic concept, known as Accounting Equation and which is as follows: ASSETS Resources of business = CAPITAL Owners investment + LIABILITIES Obligations of business

Further rules and principles have been developed on this core concept, which are applied when preparing, and maintaining business records known as BOOKKEEPING. A complete set of business records that is maintained by every business is referred as Accounting Cycle. So it can be concluded that accounting equation is not the form in which business records are being maintained however, type of records maintained (as covered by accounting cycle) and the way they are maintained is based on this concept. Every transaction has a double effect. (DUAL CONCEPT) BASIC TERMS AND DEFINITIONS A BUSINESS is an activity undertaken to earn profit PROFIT is the excess of income over expenditure LOSS is the excess of expenditure over income ASSETS are those items which are owned and controlled by a business LIABILITIES are sums of money owed by a business to outsiders such as a bank or trade payable. All that which is invested by the owner in the business is called CAPITAL DRAWINGS: Anything which the owner takes out of the business for his or her personal use CURRENT ASSETS are those assets which are expected to be converted to cash within short period of time or which are bought with the intention of resale e.g. stock, debtors, bank, cash etc CURRENT LIABILITIES: Amounts which are to be paid within one year e.g. creditors, bank over draft etc LONG TERM LIABILITIES: Amounts which can be paid after more than one year e.g. Loan TRADE CREDITORS/PAYABLES: Suppliers from whom goods are bought on credit TRADE DEBTORS/RECEIVABLES: Customers to whom goods are sold on credit STOCK: Goods ready to be sold BANK OVERDRAFT: When business borrows money from the bank and that has to be paid within specified days. This is repayable on demand LONG TERM/NON CURRENT ASSETS: These are those assets which are bought: For business use Not for the purpose of resale Life is expected to be for more than one year

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Illustration # 1
Jane Lee started business on 1 January, 20X9 and decides to set up a bookshop. She decides to invest all her personal savings $2,000 to start her business. During the first month of her business following transactions took place: 1. 2. 3. 4. 5. 6. Invested cash $2,000 in business. Purchased building for business use for $500 paying by cash. Purchased furniture on credit from Wood shop for $200. Opened a business bank account and deposited $500 cash. Repaid the amount due to Wood shop by cheque$200. Withdrew cash $100 from business for her personal use.

Required: Enter the above transaction in an accounting equation. SOLUTION Invested cash $2,000 in business Sr # Cash $ 2,000 ASSETS Building $ 500 500 ASSETS Building $ 500 500 500 ASSETS Building $ 500 500 500 500 = Furniture $ = ASSETS = CAPITAL + LIABILITIES $ 2,000 CAPITAL + LIABILITIES $ 2,000 2,000 CAPITAL + LIABILITIES Wood shop $ 2,000 2,000 2,000

1. Sr #

Purchased building for business use for $500 paying by cash. Cash $ 2,000 (500) 1,500

1. 2.

Purchased furniture on credit from Wood shop for $200. Sr # Cash $ 2,000 (500) 1,500 1,500

1. 2. 3.

200 200 = Furniture $

200 200

Opened a business bank account and deposited $500 cash. Sr # Cash $ 2,000 (500) 1,500 1,500 (500) 1,000 Bank $ CAPITAL + LIABILITIES Wood shop $ 2,000 2,000 200 2,000 200 2,000 200

1. 2. 3. 4.

200 200 200 500 500

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Repaid the amount due to Wood shop by cheque$200. Sr # Cash $ 2,000 (500) 1,500 1,500 (500) 1,000 1,000 ASSETS Building $ 500 500 500 500 500 = Furniture $ Bank $ CAPITAL + LIABILITIES Wood shop $ 2,000 2,000 2,000 2,000 2,000

1. 2. 3. 4. 5.

200 200 200 200 500 500 (200) 300

200 200 200 (200) -

Withdrew cash $100 from business for her personal use. Sr # Cash $ 2,000 (500) 1,500 1,500 (500) 1,000 1,000 (100) 900 ASSETS Building $ 500 500 500 500 500 500 = Furniture $ Bank $ CAPITAL + LIABILITIES Wood shop $ 2,000 2,000 200 2,000 200 2,000 2,000 (100) 1,900 200 (200) -

1. 2. 3. 4. 5. 6.

200 200 200 200 200 500 500 (200) 300 300

Business Equation It is commonly abbreviated as follows: Profit = Increase/(Decrease) in net assets + Drawings Capital introduced I or increase/decrease in capital or net assets = Closing capital opening capital Or Closing net assets opening net assets This equation is used as an alternative way of calculating profits of the business. In some cases instead of capital net assets figure is also used this is because if accounting equation is re arranged assets liabilities equals to capital. The assets - liabilities expression is known as net assets. In short net assets at any point in time should be equal to capital. Therefore, whether we are provided with the opening and closing capital figure or opening and closing net assets figure is given both are same and can be used interchangeably in the formula.

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CLASS ASSIGNMENT
Question No. 1
Peter Reid decides he is going to open a bookshop called Easyread, which he does by investing $5,000 on 1st January 20X7. During the first month of Easyreads existence, the following transactions occur: (a) (b) (c) (d) (e) (f) Bookshelves are purchased for $1,800 Books are purchased for $2,000 Half of the books are sold for $1,500 cash Peter draws $200 out of the business for himself Carpets are purchased for $1,000 on credit (to be paid in two months time) A bulk order of books worth $400 is sold on credit (to be paid in one months time) for $600

Required: Write down the accounting equation after each transaction has occurred.

Question No. 2
Explain the dual effects of each of the following transactions: (a) (b) (c) (d) (e) A business receives a loan of $5,000 from its bank A business pays $800 cash to purchase goods for resale The proprietor of a business removes $50 from the till to buy her husband a birthday present A business sells goods costing $300 at a profit of $140 A business repays a $5,000 bank loan, plus interest of $270

Question No. 3
Neelam decides to open up a flower stall in the market, to sell flowers and potted plants. Determine the accounting equation after each of the following transactions: (a) (b) (c) (d) (e) She puts $2,500 into her business She purchases a market stall for $1,800 She purchases flowers and potted plants from a trader in the new garden wholesale market, at a cost of $650. She sells her plants and flowers for $900 cash She pays herself $180 as wages

Question No. 4
Draw up the accounting equation for Albert after each of the following transactions: (a) (b) (c) (d) (e) (f) (g) (h) Started business with $10,000 Bought a motor van on credit for $500 Took a loan of $150 from P Puts a further $5,000 cash into the business Bought stock for $2,000 Sold stock worth $500 for $900 for cash Bought goods on credit $220 The owner takes out $100 cash for his personal use
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(i)

Repaid P

Question No. 5
Show the effect of each of the following on the accounting equation: (a) (b) (c) (d) (e) (f) (g) (h) Bought a motor van on credit $500 Repaid by cash a loan owed to P Smith $200 Bought goods for $150 paying by cheque The owner puts a further $5,000 cash into the business A debtor pays us $400 Bought goods on credit $220 The owner takes out $100 cash for his personal use We pay a creditor $190 by cheque

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MULTIPLE CHOICE QUESTIONS

1. Which of the following statement is correct? A. B. C. D. 2. Assets + Capital = Liabilities Liabilities + Capital = Assets Liabilities + Assets = Capital Assets + Liabilities = Capital

When goods are taken out of the business for personal use by owner of a business, these will be recorded as: A. B. C. D. Drawings As expense Stock A liability Building Cash balance Debtors Loan from Mr. Jims Machinery Creditors Motor vehicles Cash at bank Owners capital Petty cash Salesmens motor car Computer software Assets = Owner + Liabilities Assets Liabilities = Capital profit + drawing Net assets = assets liabilities Net assets + sales = Capital expenses drawings A creditor being paid his account by cheque Raw materials being purchased on credit Fixed assets being purchased on credit Wages being paid in cash To generate the business accounts To calculate the tax payable by a business To record, summarize and present information from documentation generated by business transactions

3.

Which of the following is not an asset? A. B. C. D.

4.

Which of the following is a liability? A. B. C. D.

5.

Which of the following is a current asset? A. B. C. D.

6.

The accounting equation can be written as: A. B. C. D.

7.

The capital of a sole trader would change as a result of: A. B. C. D.

8.

What is the main purpose of an accounting system to a business? A. B. C.

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D. 9.

To enable the owner to know if the business is trading profitably

The owner of a small business draws out some money for personal use. Which of the following correctly states the effect of drawings upon the accounting equation? A. B. C. D. Assets increase, capital increases Assets decrease, capital increases Assets decrease, capital decreases Assets decrease, liabilities decrease $50,000 $150,000 $100,000 None of the above Trade debtors Stock Bank overdraft Drawings Net assets = capital profit drawings Net assets = capital profit + drawings Net assets = capital + profit + drawings Net assets = capital + profit drawings

10.

The assets of an organization with owners equity $100,000 and liabilities $50,000 would be: A. B. C. D.

11.

Which of the following is a current liability? A. B. C. D.

12.

Which of the following describes the accounting equation? A. B. C. D.

13.

If the owner of a business withdraws cash from the business bank account in order to meet her own expenses, this is classified as drawings. This is an example of the operation of: A. B. C. D. Internal control Personal ledger accounting Segregation of duties The separate entity principle Net assets and owners capital do not change. Net assets increase and owners capital increase. Net assets decrease and owners capital decreases. Net assets increase and owners capital stays the same. Net assets increase and profit increases Net assets decrease and profit decreases Net assets remain the same and profit increases Net assets remain the same and profit decreases Bank deposit account Premises Computer
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14.

When stock is purchased on credit: A. B. C. D.

15.

When an expense is paid in cash: A. B. C. D.

16.

Which of the following is a current asset? A. B. C.

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D. 17.

Tools

Which of the following should be classified as a current asset in a business selling scaffolding equipment? A. B. C. D. Transport vehicles Scaffolding Creditors Bank loan A person to whom the business owes money in return for goods supplied A person who has purchased goods from the business A person to whom the business owes money which was lent to finance the trading operations of the business A person owing money to the business in return for goods supplied Money which the business currently has in its bank account An asset currently in use by a business An amount owed to somebody else which is due for repayment soon Something a business has or uses, which is likely to be held only for a short time Goodwill A loan from a director of the company repayable in two years time A bank overdraft Capital

18.

A trade debtor is: A. B. C. D.

19.

Which of the following best describes the term current asset? A. B. C. D.

20.

Which of the following is a current liability? A. B. C. D.

21.

Jack pays for computer equipment by a cheque from the business bank overdraft. Which parts of the accounting equation are changed by this transaction? A. B. C. D. Assets and liabilities Assets and income Liabilities and profit Capital and income Assets retained for use within the business in order to generate income or make profits Money or other items owned by the business, which will be converted to money as part of the day-to-day trading activities The amount owed by the business to the owner Amounts taken out of the business by the owner for their personal use Stock/inventory Debtors/accounts receivable Factory premises Bank overdraft Assets, capital Assets, liabilities

22.

Which of the following is the best definition of current asset? A. B. C. D.

23.

Which of the following would be a non current asset? A. B. C. D.

24.

Which parts of the accounting equation are changed by paying off a loan by cash? A. B.

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C. D. 25. A. B. C. D. 26.

Capital, liabilities Assets, capital, liabilities Assets capital = liabilities Liabilities + capital = assets Liabilities + assets = capital Assets liabilities = capital Capital $ 6,600 5,400 8,200 5,420 EFFECT UPON Assets Liabilities - Bank - Creditors + Cash + Debtors + Bank - Loan from Hall + Stock + Capital

Which of the following statements is incorrect?

Which of the following is incorrect? Assets Liabilities $ $ A. 7,850 1,250 B. 8,200 2,800 C. 9,550 1,150 D. 6,540 1,120

27.

Which of the following statements is correct? A. B. C. D. We paid a creditor by cheque A debtor paid us $90 in cash J Hall lends us $500 by cheque Bought goods on credit Items bought Goods bought on credit Goods bought for resale Goods paid for Office fixtures sold Goods sold on credit Goods sold for cash Sale of item previously included in purchases

28.

Which of the following best describes the meaning of purchases? A. B. C. D.

29.

Which of the following should not be called sales? A. B. C. D.

30.

Given the following, what is the amount of capital? Assets: Premises $20,000, Stock $8,500, Cash $100. Liabilities: Creditors $3,000, loan from A Adams $4,000. A. B. C. D. $21,100 $21,600 $32,400 $21,400 Profit does not alter capital Profit reduces capital Capital can only come from profit Profit increases capital Opening capital + drawings capital introduced closing capital Closing capital + drawings capital introduced opening capital
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31.

Which of the following is correct? A. B. C. D.

32.

A traders net profit for the year may be computed by using which of the following formulae? A. B.

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C. D. 33.

Opening capital drawings + capital introduced closing capital Closing capital drawings + capital introduced opening capital

34.

35.

36.

37.

38.

The profit earned by a business in 1997 was $72,500. The proprietor injected new capital of $8,000 during the year and withdrew goods for his private use which had cost $2,200. If net assets at the beginning of 1997 were $101,700, what were the closing net assets? A. $35,000 B. $39,400 C. $168,400 D. $180,000 The profit made by a business in 2004 was $35,400. The proprietor injected new capital of $10,200 during the year and withdrew a monthly salary of $500. If net assets at the end of 2004 were $95,100, what was the proprietors capital at the beginning of the year? A. $50,000 B. $55,500 C. $63,900 D. $134,700 A business had net assets of $32,500 at 1 st January 2004. The net profit, after proprietors drawings, for the year ended 31st December 2004 was $13,250. Drawings were made at the rate of $750 per month in cash. The proprietor also withdrew for his own use goods costing $340 and with a selling price of $800. No new capital was introduced during the year. What were the net assets at 31st December 2004? A. $35,950 B. $36,410 C. $45,750 D. $64,430 A business had net assets at 1 st January and 31st December 2004 of $75,600 and $73,800 respectively. During the year, the proprietor introduced additional capital of $17,700 and withdrew cash and goods to the value of $16,300. What profit or loss was made by the business in 2004? A. $3,200 loss B. $400 loss C. $400 profit D. $3,200 profit A business had net assets at 1 st January and 31st December 2004 of $47,100 and $54,200 respectively. During the year the proprietor introduced additional capital of $22,000 and made drawings of $200 per week. What profit or loss was made by the business in 2004? A. $18,700 loss B. $4,500 loss C. $4,500 profit D. $18,700 profit Wanda keeps no accounting records. The following information is available about her position and transactions for the year ended 31 December 2004: $ Net assets at 1 January 210,000 Drawings during 2004 48,000 Capital introduced during 2004 100,000 Net assets at 31st December 2004 400,000 Based on this information, what was Wandas profit for 2004? A. $42,000
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B. C. D.

$242,000 $138,000 $338,000

ANSWERS TO MULTIPLE CHOICE QUESTIONS

Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Answers B A D B B C D C C B C D D A B A B D D Questions 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 Answers C A B C B C C A C A B D B D B C A B C

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