Unit 3.4 Chp 1-4

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Chapter 2The Accounting equationWhere are we headed?After completing this chapter, you should be able to:• define and identify assets, liabilities and owner’sequity• explain the relationship between the Elements ofthe Accounting equation• calculate owner’s equity using the Accountingequation• explain the relationship between the Accountingequation and the Balance Sheet• define and identify current and non-current items• prepare a fully classified Balance Sheet• apply the rules of double-entry Accounting• analyse how transactions affect the Accountingequation and the Balance Sheet.Key termsAfter completing this chapter, you should be familiarwith the following terms:• equities• Accounting equation• Balance Sheet• classification• current asset• non-current asset• current liability• non-current liability• double-entry Accounting.ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University PressPhotocopying is restricted under law and this material must not be transferred to another party.
CHAPTER 2 THE ACCOUNTING EQUATION272.1 Assets, liabilities and owner’s equityThe most obvious place to start an assessment of any business is with its current situationor, if you like, its current financial position. At its most basic, this assessment will considerthe economic resources it controls – its assets – and the obligations it has – its liabilities.By preparing a Balance Sheet, which details these assets and liabilities, an owner canassess the owner’s equity – the net worth of the owner’s investment in the business.Let’s start by refreshing our understanding of how assets, liabilities and owner’sequity are defined in Accounting terms.AssetsAs was explained in Chapter 1, assets are defined as present economic resourcescontrolled by an entity as a result of past events.A common list of assets for a trading business might include the following items:• Bank – cash kept in the business’ bank account• Accounts Receivable (also known as ‘debtors’) – the amounts owed to thebusiness as a result of sales made on credit• Inventory (also known as ‘stock’) – goods purchased and held for resale tocustomers• Fixtures and fittings – items used in the business premises, such as shelving orwindow coverings• Vehicles – cars, trucks and vans used for business purposes• Premises – the building(s) from which the business activity is conducted.LiabilitiesLiabilities are present obligations of an entity to transfer an economic resource as aresult of past events.A common list of liabilities might include:• Bank overdraft – an amount owed to the bank when a business spends more thanis currently in its bank account• Accounts Payable (also known as ‘creditors’) – the amounts owed by the businessfor goods it has bought on credit• Loan – an amount that is borrowed from a bank or other financial institution thatmust be repaid at some time in the future• Mortgage – a specific type of loan that is secured against property.Thinking of assets as ‘what the firm owns’ and liabilities as ‘what the firm owes’ isfine as a starting point, but such simplistic definitions will not suffice in more complexAccounting situations (including the exam!). The more sophisticated definitions (as listedabove and described in detail in Chapter 1) must be applied to determine accurately andconclusively whether an item is an asset or a liability.Owner’s equityOwner’s equity is the residual interest in the assets of the entity after the deductionof its liabilities. Because the value of the firm’s assets must exceed its liabilities, therewill be an amount ‘left over’. Applying the Accounting entity assumption, which statesthe business is separate from the owner and other businesses, this left-over amount isthen ‘owed’ to the owner, so owner’s equity is sometimes referred to as the ‘amountowed to the owner’.What liabilities and owner’s equity have in common is that they are both equitiesor claims on the assets of the business. That is, liabilities are what the business owesto external parties, while owner’s equity is what the business owes to the owner. Bothtypes of claim must be funded from the business’s assets.equitiesclaims on the assets of abusiness, consisting of bothliabilities and owner’s equityISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University PressPhotocopying is restricted under law and this material must not be transferred to another party.
Page 1 and 2: Cambridge VCEAccountingFourth Editi
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Unit 3.4 Chp 1-4

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