Everything in accountancy starts with the accounting equation:

Assets – Liabilities = Equity

In very simple language:

• an asset is something that a business owns
• a liability is something that the business owes
• equity is the amount that belongs to the owners of the business.

A business starts by the owner investing some cash into the business.  The business therefore has the asset of cash and this also belongs to the owner of the business and so represents equity.

The cash can then be used by the business to buy goods which it can then sell in the future.  The asset of cash will decrease but the business will now have the asset of goods instead.

The business can buy further goods on credit.  This means the business does not pay the supplier immediately but instead owes the supplier – the business has a liability.  Assets increase as it has goods but it also has an equal liability.

The business then sells the goods at an amount higher than they cost and so make a profit on the sale.  The asset of goods goes down but the asset of cash increases by a higher amount.  The overall asset balance has increased.   This profit then belongs to the owner of the business.  So there is a corresponding increase in equity.

The whole purpose of being in business is to make a profit and so increase the wealth of the business’ owners.

Example

Sam is going to set up a business making cakes.

1. Sam starts the business by putting $100 into a bank account.
2. Sam buys eggs, butter and flour for $20 cash and buys $5 of sugar on credit.
3. Sam sells her first cakes for $35.

The accounting equation after each of these transactions is:

1. Sam starts the business by putting $100 into a bank account.

 2.  Sam buys eggs, butter and flour paying $20 and buys $5 of sugar on credit.

 3.  Sam sells her first cakes for $35.

Tagged: ACCA F3, ACCA F7, accounting equation, CIMA C02, CIMA F1