2.3.1 What are assets, capital and liabilities?
Assets are the economic resources belonging to a business. Assets could be money in a cash register or bank account, or items such as property, fixtures and furniture, equipment, motor vehicles, and stock or goods for resale. An important asset in businesses which sell goods or services on credit is money owed to the enterprise by customers. This asset is known as debtors.
Capital is the value of the investment in the business by the owner(s). It is that part of the business that belongs to the owner; hence it is often described as the owner’s interest.
Liabilities are the debts owed by the firm. The main types of liabilities are creditors (money owed by the business to suppliers of goods and services), bank overdrafts and bank loans.
Activity 14
A business at the end of its first year of trading has assets of £10,000 and liabilities of £8,000. What important information is contained in the difference between these two figures?
Answer
Assets of £10,000 less liabilities of £8,000 mean that the business has positive or net assets of £2,000. Another way of saying that the business has net assets of £2,000 is that the business has a net value of £2,000 belonging to the owners. (As defined above, this is the owner’s interest or capital.) Whatever the size and nature of a business, the assets minus the liabilities of the business will always equal the capital belonging to the owners.
What is the importance of knowing that, for all businesses, Assets – Liabilities = Capital?
Answer
This equation for the owner’s interest or capital (Assets – Liabilities = Capital) is known as the accounting equation. In the UK it is also known as the balance sheet equation because it reflects the format followed by accountants in the UK when preparing the financial summary of assets, liabilities and capital, which is known as a balance sheet.
Activity 15
Edgar Edwards sets up a small sole trader business as Edgar Edwards Enterprises on 1 July in the year 20X2. Complete the table below, in which the first six transactions of the business are listed in the left-most column.
Information point
The effect of each of the first three transactions, as well as the overall effect of all six transactions, has been completed for you to show you the following important aspects of the accounting equation:
- i.Each transaction will have a positive (plus) and/or a negative (minus) effect on the assets or liabilities concerned.
- ii.Assets or liabilities should be further broken down into the type of asset or liability.
- iii.For each transaction, as well as for the overall effect of a number of transactions, the figure for capital will reflect the accounting equation: A – L=C.
| Assets £ | - Liabilities £ | = Capital £ | |
|---|---|---|---|
| 1. The owner starts the business with £5,000 paid into a business bank account on 1 July 20X2. | +5,000 (bank) |
0 |
+5,000 |
| 2. The business buys furniture for £400 on credit from Pearl Ltd on 2 July 20X2. | +400 (furniture) |
+400 (creditor: Pearl Ltd) |
0 |
| 3. The business buys a computer with a cheque for £600 on 3 July 20X2. | +600 (computer) –600 (bank) |
0 |
0 |
| 4. The business borrows £5,000 on loan from a bank on 4July 20X2. The money is paid into the business bank account. | |||
| 5. The business pays Pearl Ltd £200 by cheque on 5 July 20X2. | |||
| 6. The owner takes £50 from the bank for personal spending on 6 July 20X2. | |||
| Summary (overall effect) | Total +10,150 | Total +5,200 | Total +4,950 |
Answer
| Assets £ | - Liabilities £ | = Capital £ | |
|---|---|---|---|
| 1. The owner starts the business with £5,000 paid into a business bank account on 1 July 20X2. | +5,000 (bank) | 0 | +5,000 |
| 2. The business buys furniture for £400 on credit from Pearl Ltd on 2 July 20X2. | +400 (furniture) | +400 (creditor: Pearl Ltd) | 0 |
| 3. The business buys a computer with a cheque for £600 on 3 July 20X2. | +600 (computer) –600 (bank) |
0 | 0 |
| 4. The business borrows £5,000 on loan from a bank on 4July 20X2. The money is paid into the business bank account. | +5,000 (bank) | +5,000 (loan) | 0 |
| 5. The business pays Pearl Ltd £200 by cheque on 5 July 20X2. | –200 (bank) | –200 (creditor: Pearl Ltd) | 0 |
| 6. The owner takes £50 from the bank for personal spending on 6 July 20X2. | –50 (bank) | 0 | –50 |
| Summary (overall effect) | Total +10,150 | Total +5,200 | Total +4,950 |
How does the summary or overall change in the table above relate to the accounting equation?
Applying the accounting equation, A – L = C, we see that the overall change in assets in the period (+£10,150) less the change in liabilities in the period (+£5,200) is equal to the change in capital in the period (+£4,950).
What is noticeable about the accounting equation after every transaction in the table above?
The accounting equation remains in balance as every transaction must alter both sides of the equation, A– L= C, by the same amount. This can be shown by looking at the six transactions above as follows:
- £400 – £400 = £0 (both sides of the equation increase by £0)
- (£600 – £600) – £0 = £0 (both sides of the equation increase by £0)
- £5,000 – £5,000 = £0 (both sides of the equation increase by £0)
- –£200 – (–£200) = £0 (both sides of the equation increase by £0)
- –£200 – (–£200) = £0 (both sides of the equation increase by £0)
Every transaction above is thus recorded twice in order to keep the accounting equation in balance. This dual effect is known as the dual aspect concept and is the basic principle associated with both the double-entry bookkeeping system and the production of the balance sheet. We will look at the double-entry bookkeeping system in more detail later in this section, but will look more closely at the balance sheet in '2.4 A simplified UK balance sheet formula'.
What then is the dual aspect concept and how does it relate to the accounting equation?
The dual aspect concept is that every transaction has two aspects which must be equal in order to keep in balance the accounting equation, A – L= C.