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Fundamentals of accounting
Fundamentals of accounting

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4.5 The effect of profit on the accounting equation

In both Week 2 and Week 3 we looked at the accounting equation:

Table 3 The accounting equation
Assets = Capital + Liabilities

The three elements (assets, capital and liabilities) are presented in the balance sheet. The profit earned by the business increases capital, and we have already seen that Profit = Income/Revenue – Expenses. The accounting equation can, therefore, be expanded to:

Table 4 The expanded accounting equation
Assets = Liabilities + Capital + (Revenue – Expenses)

The income statement (also known as the profit and loss statement) shows in detail the elements of the equation: Revenue – Expenses = Profit or Loss. A deep understanding of the income statement is beyond the scope of this free course. An understanding of such a statement, as well as much other useful material, is included in the Open University module, B124 Fundamentals of accounting.