The accounting equation and the balance

THE ACCOUNTING EQUATION AND THE BALANCE

Introduction

For a business to start up its operations, it requires resources which are supplied partly by its owners and partly by outsiders. The resources that are supplied by both owners and outsiders, such as cash, land and building, cars, computers and so on, are known as assets.

The resources supplied by outsiders to the business will give rise to financial obligation or debt to the business. This financial obligation is called liability.

The resources contributed by owners themselves will also give rise to another liability called capital or owners equity. Therefore capital or owners equity is a “special” form of liability and is therefore shown separately from the other liability. The relationship of the above can be seen in the balance sheet.

A balance sheet is a financial statement which shows the financial position of a business. It shows the assets, liabilities and capital of an organization. Net profit or loss and drawings are as well shown in the balance sheet. It is also called the statement of financial position.

DEFINITION OF TERMS:

ASSETS

Assets are the resources or properties controlled by a business. Assets can be divided into

       a.          Current assets

      b.          Fixed Assets ( Non-current assets)

       c.          Tangible Fixed  Assets

      d.          Intangible Fixed  Assets

       e.          Fictitious assets

       f.          Wasting Assets

      g.          Liquid Assets

Fixed  Assets or Non-current Assets 

    These are the assets bought with the intention of using them permanently or a long time in a business for generating revenue. They are bought with no intention of resale but to assist in producing goods and services or for generating income. Examples include plant and machinery, furniture, motor vehicles, land and building and so on.

Current Assets 

     These are assets bought with the intention of turning them into cash or resale and are constantly changing from cash to stock to debtors to cash, etc in the ordinary day-to-day activities of a business. They are assets held for a short term, usually one year. Examples include cash, trading inventory (stock), bank account balances, etc.

Tangible Fixed Assets 

     These are that which have physical existence like building, motor vehicle, etc. They can normally be touched, seen and felt.

Intangible Assets 

    These are that which have no physical substance or physical existence. Examples include copyright, patent, goodwill, investment, etc.  They normally cannot be touched, seen and felt.

Fictitious Assets 

     These are expenses or losses that are capitalized. Examples include pre-incorporation losses or expenses. ( i.e. Preliminary expenses )

Wasting assets  

     are assets that are that get finished or depleted as and when it is used. Examples include stone quarry, mining, etc.

Liquid assets 

     These are assets that can easily be changed into cash to meet maturing feature obligations. E.g: debtors, prepaid expenses among others

Liability  refers to the financial obligation of a business. That is, the amount owed by a business to people who are not part of the owners of the business. Any form of debt to a business is called liability. Liabilities can be divided into

1.      Long-term or non-current Liability: It refers to the financial obligation of a business which is repayable after more than one accounting year. Examples are long-term loans or debentures.

2.      Current Liability: It is any financial obligation of a business which is repayable within one accounting year. It  is also called short-term liability. Examples are trade creditors, bank overdraft, expenses in arrears, etc.

The relationship between capital, liability and assets can be expressed in terms of the following equation known as the Accounting Equation. Accounting equation can, therefore, be defined as a mathematical statement that shows the link between assets, capital, and liabilities. It is shown below.

 Assets = Capital + Liabilities

Example 1

Saviola started a business on January 1^st, 2006. He transferred his personal bank with the balance of$700,000 and a cash of$200,000 into the business. He decided to use his house valued at$8,000,000 as a business property. A loan of$900,000 was taken from his in-law. Other resources of the business amounted to$550,000. Calculate the capital of Saviola’s business.

Capital: Capital is the part of the total resources which is contributed by the owner or owners of a business. Capital can be classified into various forms. These are

1.      Working Capital: It is defined as the excess of current assets over current liabilities. In other words, it is the amount available to meet the ordinary day-to-day expenses of running a business.

2.      Capital Employed: This refers to all the assets of a business. It implies that                                         

Capital Employed = Total Assets or

      Capital Employed = Capital + Total Liability

      Some writers define capital employed as ‘total assets less current liabilities’. That is,

      Capital Employed = Total Assets – Current Liability

3.      Capital Owned or Owner’s Equity: It refers to all assets less total liabilities. It is also known as Net Assets. That is, Capital Owned = Total Assets – Total Liabilities

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