Chapter 1: The Accounting Equation &
Statement of Financial Position
Learning Objectives
After studying this chapter, you should be able to:
• Explain what accounting is
• Describe the history of accounting
• Explain the link between bookkeeping and accounting
• Identify users of accounting information and their needs
• Understand and explain the accounting equation
• Link the accounting equation with the statement of financial position
• Define key terms:
o Assets
o Capital
o Liabilities
o Accounts receivable (debtors)
o Accounts payable (creditors)
• Explain how transactions affect the accounting equation
• Prepare statements of financial position after transactions
1. Introduction
In this chapter, you learn:
• What accounting is
• How it developed
• Who uses it
• How the accounting equation works
2. What is Accounting?
Definition:
Accounting is:
The process of identifying, measuring, and communicating financial information to help
users make decisions.
Simple Meaning:
• It tracks money in business
• Organizes financial data
• Helps in decision-making
Important Points:
• Not a branch of mathematics
• Only basic math is needed (add, subtract, multiply, divide)
• Helps you know:
o What you own
o What you owe
3. History of Accounting
Why Accounting Started:
• To record transactions
• To know what people own and owe
Timeline:
• Exists for 10,000+ years
• Used in:
o Mesopotamia
o Egypt, China, India, Greece, Rome
• England’s oldest record: Pipe Roll (1130–1830)
Important Systems:
• India: Bahi-khata system
• First double-entry record: 1299 (Italy firm)
Luca Pacioli (Father of Accounting):
• Book published in 1494
• Explained double-entry bookkeeping
• Still used today
4. Conditions Needed for Accounting Development
Seven important factors:
1. Private property
2. Capital (wealth used in business)
3. Commerce (trade)
4. Credit (buy now, pay later) → most important
5. Writing
6. Money
7. Arithmetic
5. Development of Bookkeeping System
Old System:
• Transactions written in Ricordanze (record books)
Improved System:
1. Memorandum (basic notes)
2. Journal (organized entries)
3. Ledger (accounts)
This became double-entry bookkeeping
6. Accountants
Then:
• Called bookkeepers
• Recorded transactions
Now:
• Record + analyze + interpret data
• Help in decision-making
Professional Bodies:
• First: Venice (1581)
• Scotland (1854)
• England (1880)
• USA (1887)
Today:
• ~200 accounting bodies worldwide
7. Professional Ethics
Meaning:
Being honest, fair, and responsible in all situations
Key Principles:
1. Integrity – honesty
2. Objectivity – no bias
3. Competence – proper skills
4. Confidentiality – keep information private
5. Professional behaviour – follow laws
Why Important?
• Protect profession’s reputation
• Prevent scandals
• Maintain trust
8. Objectives of Accounting
Accounting helps to know:
• Profit or loss
• Business value
• Cash available
• Wealth
• Amount owed to and by business
Main Objective:
Provide information for decision-making
9. Accounting in Daily Life
• Used in budgeting
• Planning expenses and savings
10. Accounting Process
Accounting involves:
1. Recording
• Writing financial data
2. Classifying & Summarising
• Organizing data
3. Communicating
• Sharing useful information
11. Bookkeeping vs Accounting
Bookkeeping:
• Recording transactions
Accounting:
• Using that data to make decisions
12. Users of Accounting Information
1. Managers → decision-making
2. Owners → profit & resources
3. Buyers → business value
4. Banks → loan decisions
5. Tax authorities → tax calculation
6. Partners → investment decisions
7. Investors → investment choices
8. Creditors → payment security
Important Note:
• Accounting mainly focuses on owners
• Others are called stakeholders
13. Accounting Equation
Basic Idea:
Business value = what it owns − what it owes
Forms:
1. Basic form:
Capital = Assets − Liabilities
2. Common form:
Assets = Capital + Liabilities
Meaning:
• Assets = resources
• Capital = owner’s investment
• Liabilities = debts
14. Definitions
Assets:
Things owned by business
(e.g., cash, buildings, inventory)
Liabilities:
Amounts owed
(e.g., creditors, loans)
Capital:
Owner’s investment + profit − withdrawals
Accounts Receivable (Debtors):
People who owe money to business
Accounts Payable (Creditors):
People business owes money to
15. Key Rule
The accounting equation always stays balanced.
16. Statement of Financial Position (Balance Sheet)
Definition:
Shows financial position at a specific date
Structure:
• Top → Assets
• Bottom → Capital & Liabilities
17. Effect of Transactions
Key Rule:
Every transaction affects two items
Types of Effects:
1. Increase asset + increase capital
2. Increase asset + decrease asset
3. Increase asset + increase liability
4. Decrease asset + increase asset
5. Decrease asset + increase asset
6. Decrease asset + decrease liability
7. Increase asset + decrease asset
Special Cases:
8. Owner withdraws money
o ↓ Asset, ↓ Capital
9. Owner pays business debt personally
o ↓ Liability, ↑ Capital
18. Important Concept
• Equation always stays equal
• Total assets = total capital + liabilities
• Business value remains same unless capital changes
19. Types of Assets & Liabilities
Non-current assets:
• Long-term use
• Example: buildings, machinery
Current assets:
• Short-term (within 1 year)
• Example: cash, inventory
Current liabilities:
• Pay within 1 year
• Example: creditors
20. Key Learning Points (Summary)
1. Accounting records, organizes, and communicates data
2. Exists for 10,000+ years
3. Many users need accounting info
4. Helps in planning decisions
5. Accounting equation:
Capital = Assets − Liabilities
6. Statement of financial position shows this equation
7. Both sides always equal
8. Every transaction affects two items
9. Equation always remains balanced
Review Questions
1.1 Fill the Table (Using: Capital = Assets − Liabilities)
(a) Capital = 20,000 − 3,400 = 16,600
(b) Capital = 23,000 − 8,800 = 14,200
(c) Liabilities = 19,200 − 3,200 = 16,000
(d) Liabilities = 8,100 − 6,500 = 1,600
(e) Assets = 17,300 + 7,900 = 25,200
(f) Assets = 51,900 + 18,500 = 70,400
1.2A
(a) Capital = 55,000 − 16,900 = 38,100
(b) Assets = 34,400 + 17,200 = 51,600
(c) Liabilities = 36,100 − 28,500 = 7,600
(d) Capital = 119,500 − 15,400 = 104,100
(e) Liabilities = 88,000 − 62,000 = 26,000
(f) Assets = 110,000 + 49,000 = 159,000
1.3 Assets vs Liabilities
(a) Loan from A. Sangster → Liability
(b) We owe supplier → Liability
(c) Equipment → Asset
(d) Bank overdraft → Liability
(e) Inventory → Asset
(f) Loan to F. Wood → Asset
1.4A
Assets:
• Motor vehicles
• Premises
• Cash in hand
• Inventory
• Accounts receivable
• Machinery
Liabilities:
• Owing to bank
• Accounts payable
• Loan from D. Jones
1.5 Wrong Classifications
Item Correct
Loan to C. Smith Asset (correct)
Delivery van Asset (wrong → not liability)
Mortgage Liability (correct)
Accounts payable Liability (correct)
Accounts receivable Asset (correct)
Office supplies Asset (wrong)
Warehouse Asset (correct)
Computers Asset (wrong)
Website Asset (correct)
Cash in hand Asset (wrong)
1.6A Wrong Headings
Wrong items:
• Fixtures → Asset
• Machinery → Asset
• Motor vehicles → Asset
• Capital → NOT liability
1.7 Capital Calculation
Assets:
Van = 13,000
Stall = 1,050
Computer = 450
Inventory = 8,000
Cash = 1,400
Bank = 4,700
Total Assets = 28,600
Liabilities:
Inventory owed = 3,000
Loan = 10,000
Total Liabilities = 13,000
Capital:
Capital = 28,600 − 13,000 = 15,600
1.8A
Assets:
Fixtures = 1,200
Van = 6,000
Inventory = 2,800
Bank = 200
Cash = 175
Total = 10,375
Liabilities:
Inventory owed = 1,600
Loan = 2,500
Total = 4,100
Capital:
Capital = 10,375 − 4,100 = 6,275
1.9 Statement of Financial Position
Assets:
Car = 8,300
Equipment = 7,900
Inventory = 5,700
Receivable = 800
Bank = 1,600
Total Assets = 24,300
Liabilities:
Accounts payable = 3,600
Net Assets:
24,300 − 3,600 = 20,700
Capital:
20,700
1.10A
Assets:
Equipment = 3,400
Inventory = 3,600
Receivable = 4,500
Bank = 2,800
Total = 14,300
Liabilities:
Accounts payable = 4,100
Capital:
14,300 − 4,100 = 10,200
1.11 Effects
Transaction Assets Liabilities Capital
(a) Pay creditor ↓ ↓ —
(b) Buy fixtures cash ↔ — —
(c) Buy goods credit ↑ ↑ —
(d) Owner adds cash ↑ — ↑
(e) Loan received ↑ ↑ —
(f) Debtor pays ↔ — —
(g) Return goods ↓ ↓ —
(h) Buy computer cheque ↔ — —
1.12A
(a) ↑ Assets, ↑ Liabilities
(b) ↓ Assets, ↓ Liabilities
(c) ↔ Assets
(d) ↑ Assets, ↑ Capital
(e) ↓ Assets
(f) ↑ Assets, ↑ Liabilities
(g) ↓ Assets, ↓ Capital
(h) ↓ Assets, ↓ Liabilities
1.13 Statement (7 May 2012)
Original Assets:
Fixtures 9,600
Car 12,300
Inventory 8,600
Receivable 4,100
Bank 1,600
Cash 2,900
Total = 39,100
Liabilities = 7,400
Adjustments:
(a) Inventory +1,100, Liability +1,100
(b) Receivable −450, Bank +450
(c) Computer +610, Bank −610
New Assets:
Fixtures = 9,600
Car = 12,300
Inventory = 9,700
Receivable = 3,650
Bank = 1,440
Cash = 2,900
Computer = 610
Total = 40,200
Liabilities:
7,400 + 1,100 = 8,500
Capital:
40,200 − 8,500 = 31,700
1.14A
Initial Assets:
Equipment 6,200
Car 7,300
Inventory 8,100
Receivable 4,050
Bank 9,100
Cash 195
Total = 34,945
Liabilities = 2,800
Capital = 34,945 − 2,800 = 32,145
Adjustments:
(a) Equipment +110, Liability +110
(b) Inventory +380, Bank −380
(c) Bank −1,150, Liability −1,150
(d) Receivable −730, Bank +640, Cash +90
(e) Bank +1,300, Cash +200, Capital +1,500
Final Assets:
Equipment = 6,310
Car = 7,300
Inventory = 8,480
Receivable = 3,320
Bank = 8,510
Cash = 485
Total = 34,405
Liabilities:
2,800 +110 −1,150 = 1,760
Capital:
32,145 +1,500 = 33,645