Chapter 2

Assets, Liabilities and the

Accounting Equation

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 Contents

1. Elements Of The Financial Statements

2. Assets liabilities and Capital
3. The accounting equation
4. Accounts payable and accounts receivable
5. Double entry bookkeeping
6. Capital expenditure and revenue expenditure
7. Duality of transactions and the double entry system
8. Double entry system
9. Define the accounting equation
10. Understand and apply the accounting equation
11. Understand how the accounting equation relates to the double entry
bookkeeping system.
12. Process financial transactions from the books of prime entry into the
double entry bookkeeping system.

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 What is Financial Accounting?

Financial Accounting

is the process of recording, summarizing and

reporting the myriad of a company's
transactions to provide an accurate picture of
its financial position.

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Definition of Accounting
Accounting consists of two elements

Recording (Bookkeeping) Summarising (Reporting)

Transactions must be The transactions for a period
recorded as the occur in Are summarised in order to
Order to provide up-to- Provide the information about
Date information for the The company to the interested
management parties

Financial Statements
Income Statement
Balance Sheet

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 Elements Of The Financial Statements

There are five elements of accounting.

1.Asset
2.Liability
3.Capital
4.Income
5.Expense

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 Asset

Asset

An asset is a resource which a business controls and which

is used to generate future economic benefits for a
business. It could either be sold for cash or could help the
business to generate sales income and profits. An example
of an asset used to generate future economic benefits is
plant and equipment used by a business to produce goods
to sell to customers.

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 Liability

A liability is an amount which the business owes to another party.

This could be a bank loan or overdraft outstanding, or amounts owed

to suppliers for goods received but not yet paid for.

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 Capital

Capital
Capital is the amount due to the owner
of a business after liabilities have been
paid.

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 Income

Income
The principal source of income for a business is the
amount generated from the sale of goods or services
to customers during an accounting period. This is
often referred to as sales income or sales revenue.
Income is also regarded as an inflow or increase in
economic benefits during an accounting period.

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 Expense

Expense
An expense is incurred by a business to enable it to
make sales and generate income. Examples of expenses
incurred by a business include telephone, stationery
and postage costs, or heat, fuel and power charges for
gas and electricity usage. In effect, expenses are
resources used up during an accounting period to help
the business generate revenue.

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 Statement of Financial Position

This is a statement of assets and liabilities of the business

compiled at a specific date. It consists of the assets, liabilities
and capital of the business at that date. Assets may be
classified as being either current assets or non-current assets.
Liabilities can also be classified as being either current or non-
current depending upon when they fall due to be paid.

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Statement of Profit or Loss and other
Comprehensive Income

This statement summarizes the income and expenses of a

business for a period. The difference between income and
expenses is the profit or loss made by the business during
that accounting period. This statement is often abbreviated to
‘the statement of profit or loss’ and, for the purposes of your
studies for this paper, it will be referred to as the ‘statement
of profit or loss’.

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 Separate Entity Concept

A business is separate from its owner(s)

The separate entity concept (also known as business entity) states that the
transactions related to a business must be recorded separately from those of its
owners and any other business. In other words, while recording transactions in a
business, we consider only those events that affect that business; the events that
affect anyone else other than the business entity are not relevant and are
therefore not included in the accounting records of the business.

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 Separate Entity Concept

Separate Entity
Concept
The separate entity concept is that, from an
accounting perspective, a business is treated
as an entity, separate from its owner, no
matter what the actual legal position happens
to be.

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 Assets

Assets
A business invests in equipment, motor vehicles,
materials and other items. Items that a business
controls, including money in the bank, are called
assets. Assets are divided into two types.
• Current Assets
• Non-Current Assets

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 Non-Current/ Fixed Assets

Non-current/ Fixed
Assets
Some assets are held and used in operations for a
long time. An office building can be occupied by
administrative staff for years. Similarly, a machine has
a productive life of many years before it wears out.
These are usually referred to as non-current assets.

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 Current Assets

Current Assets
• Other assets are held for only a short time. The owner of a newsagent's shop, for example,
must sell his newspapers on the same day that he gets them, and weekly newspapers and
monthly magazines also have a short shelf life. The more quickly a business can sell the goods
it has in store, the more profit it is likely to make.
• When a business acquires an asset that it expects to use or consume within a year then it is
referred to as a current asset. Inventory is an example of a current asset as
• businesses do not tend to hold onto inventory for too long because of the increased risks of
damage and the storage costs.

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 Current Assets

Current Assets

• We usually call these current assets.

• Examples of current assets include:
• inventory
• receivables
• cash in a bank account
• petty cash (notes and coins)
• payments in advance.

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 Liabilities

Liabilities

• Liabilities are sums of money owed by a business to

outsiders such as a bank or a trade account payable.
• Current liabilities (short-term liabilities) are liabilities
that are due and payable within one year.
• Non-current liabilities (long-term liabilities) are
liabilities that are due after a year or more.

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 Current Liabilities

Current Liabilities

Current liabilities, also known as short-term liabilities, are

debts or obligations that need to be paid within a year.
Examples of current liabilities:
• Accounts Payable
• Income taxes payable
• Short-term loans
• Bank account overdrafts
• Interest payable
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 Non-Current Liabilities

Non-Current Liabilities
Long-term liabilities are an important part of a company’s
long-term financing. Companies take on long-term debt to
acquire immediate capital to fund the purchase of capital
assets.
Some examples of Non-current liabilities:
• Long-term borrowings
• Mortgage payable
• Long-term loans from banks

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Elements of Accounting

• Income
OPEX – Operating Expenses - Salaries, Rent Exp, Utilities,
Transportation, Advertising, Insurance, Depreciation etc.
• Expenses CAPEX – When a Non Current Asset is purchased

▪ Current Assets – Cash, Trade Receivables,

• Assets Inventory, Advances
▪ Non - Current Assets – Land and Building,
Plant and Machinery, Motor Vehicles, Furniture
▪ Current Liabilities
• Liabilities Payable within one year
and Fixture, Computer Equipment etc.

▪ Non Current Liabilities

• Capital Payable after one year

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Elements of Accounting

• Income Income Statement

Profit = Income – Expenses (OPEX)
FINANCIAL PERFORMANCE
• Expenses
Balance Sheet (Statement of Financial Position - SOFP)
• Assets
Assets = Capital + Liabilities

• Liabilities OR

Assets = Equity + Liabilities

• Capital FINANCIAL POSITION

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 The Accounting Equation

Formula to Learn
Assets = Capital + Liabilities

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 Example: The Accounting Equation

Example: The
Accounting Equation
• On 1 July 20X7, Neelim Sultan decides to open a flower
stall in the market, to sell flowers and potted plants.
She has $2,500 to put into her business.
• When the business is set up, an 'accountant's picture'
can be drawn of what it owns and what it owes.
• The business begins by owning the cash that Neelim
has put into it, $2,500. Does it owe anything?
• The answer is yes.

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 Example: The Accounting Equation

Example: The Accounting Equation

• The business is a separate entity in accounting terms. It has obtained its assets, in
this example cash, from its owner, Neelim Sultan. It therefore owes this amount
of money to its owner. If Neelim changed her mind and decided not to go into
business after all, the business would be dissolved by the 'repayment' of the cash
by the business to Neelim.
• The money put into a business by its owners is capital. If that money is invested,
accountants will treat the capital as money owed to the proprietor by the
business.

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 Assets = Capital + Liabilities

Capital is an investment of money (funds) with the intention of earning a

return. A business proprietor invests capital with the intention of earning profit.
The business owes the capital and the profit to the proprietor.

Capital invested is therefore a form of liability. Adapting this to the idea that
liabilities and assets are always equal amounts, we can state the accounting
equation as follows.

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 For Neelim Sultan, as of 1 July 20X7

Assets Capital Liability

$2500 $2500 $0

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