1.2 The Accounting Equation

 
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1.2 The Accounting Equation

Definition: The accounting equation is the foundation of the double-entry accounting system. It represents the relationship between  assets, liabilities, and owner's equity of a business.

Equation: $\text{Assets }= \text{Liabilities }+ \text{Owner’s Equity}$

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$\text{<b>Question </b>}$Which formulas may be used for the accounting equation?

1 assets = owner’s equity minus liabilities
2 liabilities = assets minus owner’s equity
3 owner’s equity = assets plus liabilities
4 owner’s equity plus liabilities = assets

A 1 and 2       B 1 and 3       C 2 and 4        D 3 and 4

 Answer C 2 and 4

1. Assets, Liabilities, and Owner’s Equity

Assets: Resources owned by a business that have economic value. OR resources used within the business for its activities.

Example: Cash, Bank, inventory, equipment.

There are 2 types of Assets 

Current Assets: Resources owned and used by the business within a year. 

Examples:

1. Cash in hand or at the bank
2. Inventory (goods for sale)
3. Trade receivables (money owed by customers)
4. Prepaid expenses (like rent or insurance you’ve paid in advance)

Non Current Assets: Resources owned and used by the business for more than one year

Examples:

1. Land and buildings
2. Machinery and equipment
3. Vehicles
4. Computers and office furniture

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Liabilities: Amounts owed by an business to other business or individuals. OR amounts borrowed to fund business activity.

  

Example: Loans, trade payable (accounts payable)

There are 2 types of Liabilities

Current Liabilities: The amount owed by the business which must be repaid within a year

Example: 

1. Trade payables (money you owe to suppliers)
2. Short-term loans or overdrafts
3. Accrued expenses (like wages you owe but haven’t paid yet)
4. Taxes payable (taxes you need to pay soon)

Non-Current Liabilities: The amount owed by the business which is scheduled to be repaid in more than a year.

Example: 

1. Long-term loans (like a mortgage on your shop building)
2. Lease obligations (for equipment or property leased over a long period)
3. Debenture (Its a long term liability issued by the business to its debenture holders)

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Owner’s Equity (Capital): The owner’s claims to the assets of the business. OR business resources supplied by the owner of the business

Example: Capital, retained earnings.

Question: Which of the following is considered an asset?

A) Bank loan
B) Inventory
C) Trade payable
D) Mortgage

Answer: B) Inventory

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2. Applying the Accounting Equation

Explanation: The equation ensures that the statement of financial position (balance sheet) remains balanced, showing that all assets are financed by either liabilities or owner's equity.

Example:

A business has $50,000 in assets, $20,000 in liabilities, and $30,000 in owner's equity.

Calculation:    Assets=Liabilities + Owner’s Equity

                       50,000=    20,000  +  30,000

Question: A business has assets of $100,000 and liabilities of $40,000. What is the owner's equity?      

A) $60,000
B) $140,000
C) $40,000
D) $100,000

Answer: A) $60,000

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Extra Questions

1. Explain the role of accounting in business decision-making.

2. Describe the differences between book-keeping and accounting.

3. Calculate the owner’s equity if a business has assets worth $120,000 and liabilities of $50,000.

Answers:

1. Accounting provides critical financial data that helps in strategic planning, monitoring progress, and making informed decisions about investments, cost management, and overall business operations.

2. Book-keeping involves recording financial transactions, while accounting encompasses interpreting, analyzing, summarizing, and reporting these transactions.

3. Owner’s equity = $120,000 - $50,000 = $70,000.

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