1The accounting equation
Accounting equation is a formula that is used to illustrate the relationship between the assets,
liabilities and owner’s equity of a business.
1. Owner's Equity (Capital):
o Definition: Resources supplied by the owner to the business, such as cash or
motor vehicles.
o Resources the business owes the owner.
o Separate Entity Concept: The owner and the business are separate entities.
When the owner supplies resources, the business owes the owner for those
resources.
o Owner's Equity Formula: Owner's Equity = Assets – Liabilities.
o Importance: It represents the owner's investment and is used to fund business
activities.
2. Assets:
o Definition: Resources owned by the business that have monetary value and
can generate income.
o Resources owned by the business.
o Assets = Owner’s equity + Liabilities
o Examples of Assets:
Cash (in hand), Bank (money in the bank), Motor vehicles, Land,
Buildings.
o Types of Assets:
Current Assets: Assets that can be converted into cash within one
year, e.g., cash, Bank,
Inventory; Goods purchased by the business for resale.
Prepaid expenses: Payments made in advance for services or
products to be received in the future (e.g., rent, insurance).
short term investments; Investments that can be quickly
converted into cash, usually within a year and
Trade receivables: Money owed to the business by customers
who have bought goods on credit
Non-Current Assets: Assets held for long-term use (more than a year)
to generate revenue, e.g., motor vehicles, machinery, and premises.
Liquid Assets: Assets that can be quickly converted to cash without
losing value.
3. Liabilities:
o Definition: Debts or obligations owed by the business to others, such as loans
or amounts payable to suppliers.
o Liabilities = Assets – Owner’s equity
o Examples of Liabilities:
Trade payables
Bank loans
Overdrafts
o Types of Liabilities:
Current Liabilities: Debts to be paid within one year, e.g., trade
payables and overdrafts.
Non-Current Liabilities: Long-term debts that do not need to be paid
within a year, e.g., long-term loans.
4. Accounting Equation:
o Formula:
Assets = Owner's Equity + Liabilities.
Owner's Equity = Assets – Liabilities.
Liabilities = Assets – Owner’s equity
o Explanation: This equation shows that everything the business owns (assets)
is financed either by the owner's investment (equity) or by borrowings
(liabilities).
o This equation is the foundation of accounting make sure that you remember it.
o Important Note: The equation must always balance, meaning both sides
(assets and the combination of equity and liabilities) have equal value.
o e.g. Owner’s Equity = Assets – Liabilities
$280,000 = $400,000 – $120,000
5. Drawings:
o Definition: When the owner takes money or inventory out of the business for
personal use, this reduces owner's equity.
6. Inventory:
o Definition: Goods purchased by the business for resale. Inventory is an asset.
o Types of Inventory:
Opening Inventory: The inventory available at the start of the
financial year.
Closing Inventory: The unsold inventory remaining at the end of the
financial year.
Summary
Owner’s Equity: What the business owes the owner.
Assets: What the business owns.
Liabilities: What the business owes to others.
The accounting equation balances these components and helps in preparing financial
statements like the Statement of Financial Position (listing assets, liabilities, and
equity at a specific time).
Exercise 1
1. Using the concept of accounting equation, compute missing figures from the
following:
a. Assets = $100,000, Liabilities = $40,000, Owner’s equity = ______________
b. Assets = ______________, Liabilities = $20,000, Owner’s equity = $30,000
c. Assets = $120,000, Liabilities = _____________, Owner’s equity = $80,000
d. Assets = _____________________, Liabilities + Owner’s equity = $300,000
2. Activity 1
3. Activity 3
