Chapter 2

• The accounting equation is also known as the statement of financial position.

  The statement of financial position is a detailed expansion of the equation showing assets, liabilities and capital.
• Assets: resources owned or controlled by the business and are expected to generate economic benefit in the future.

  Assets can be split into two types:

  • Non-current Assets - greater than 12 months, long term use for the business. E.g. land and buildings, motor vehicles and machinery
  • Current Assets - less that 12 months, acquired for resale or expected to be realised within the normal course of trading. E.g. inventory, receivables and cash
• Liability: an obligation as a result of past event to transfer economic benefit in the future.

  Liabilities can be split into two types:

  • Non-current liabilities: payable more than 12 months after the statement of financial position date e.g. a loan
  • Current liabilities: payable within 12 months of the statement of financial position date e.g. trade payables, overdraft
• Business entity concept (separate entity concept) states that financial statements should only show the activities of the business and not the personal activities of the owners. From an accounting perspective the business is treated as a separate legal entity from its owner. Any flows of money between the business and owner are to be reported within the statement of financial position.
• Capital within a sole trader is the amount the business owes back to the owner.

  Balance at the start of the year + net profit + injections - drawings = Balance at the end of the year.
• The Accounting Equation:

  A business will buy assets using borrowed funds or capital from its owner, therefore the accounting equation always holds true.

  Assets = Liabilities + Capital

  or

  Assets - Liabilities = Capital

  Capital = Opening Capital + Profit + Injections - Drawings
• Final Accounting Equation:

  Assets - Liabilities = Opening Capital + Profit + Injections - Drawings

  Everytime a transaction takes place, the accounting equation must be updated. This means every transaction must have a dual effect in order for the equation to remain balanced.
• Duality concept: states that every transaction has a dual effect.
• The statement of profit and loss show how the profit figure included in the calculation for capital has arisen.

  It shows income less expenses over a period of time.

  If income is less than expenses it will show a loss.
• There are two types of sales:

  • Cash sales - will increase cash
  • Credit sales - will increase trade receivables, allowing customers to pay later
• The SPL needs to reflect how much is has cost the business to make its sales. Meaning cost of sales in important.

  Cost if sales = opening inventory + purchases - closing inventory

  Opening inventory: inventory held in the business on the fort day of the period

  Purchases: what the business bought during the period to sell (cash and credit purchases)

  Closing inventory: inventory held in the business on the last day of the period
• Expenses: running costs of the business and will reduce profits which reduces capital. When dealing with a sole trader set of accounts, all of the different types of expenditure are included as separate figures on the SPL.
• Throughout the year revenue and expenses are recorded in the SPL. At the year end date the profit and loss is transferred to capital in the SPL. The SPL then resets to zero.