CHAPTER 2: ASSETS, LIABILITIES, THE ACCOUNTING EQUATION DOUBLE ENTRY BOOK-KEEPING

Assets
An asset is something valuable which a business owns or has the use of.
Examples of assets are factories, office buildings, warehouses, delivery vans, lorries, plant and
machinery, computer equipment, office furniture, cash, goods held in store awaiting sale to customers,
and raw materials and components held in store by a manufacturing business for use in production.

Types of
CURRENT ASSET NON-CURRENT ASSET
Assets

 Expected to be used up, sold or  Expected to be used by a

collected in a short period (less than a business over several years.
Differences year)  Does not convert to cash easily
 Converts to cash easily
 Inventory  Buildings
 Trade receivables  Motor vehicles
Examples
(money owed by customers)  Equipment and machinery
 Cash and bank

Liabilities
A liability is something which is owed to somebody else.
'Liabilities' is the accounting term for the debts of a business. Debts are owed to accounts payable.

Types of
CURRENT LIABILITY NON-CURRENT LIABILITY
Liability

 Liabilities which are due for payment  Liabilities which are not due for
Differences in a short period (within one year) payment within one year

 Trade Payables  Bank Loans

(money owed to suppliers) (repayable over more than 1
 Bank Overdraft year)
Examples (bank balance in negative position)  Other long-term borrowings
 Tax Liabilities
(money owed to tax authorities)

The Accounting Equation

Assets = Capital + Liabilities
It states that the assets and liabilities of a business must always be equal (the accounting equation).
Let's demonstrate this with an example, which we will build up during this chapter:

Transaction 1
The owner starts up the business on 1/1/2013 by putting $10,000 of cash in as capital.
From the business’s point of view, its cash has increased by $10,000 and its capital has increased by
$10,000. Cash is an asset (something owned) and the capital is the amount owed by the business back to
its owner.
Accounting equation:
Things owned, cash $10,000 = Things owed, capital 10,000

Transaction 2
The business buys some equipment for $2,000 cash on 3/1/2013.
Cash has decreased by $2,000 and the cost (or value) of equipment (an asset) has increased by $2,000
Accounting equation:
Things owned, cash $8,000 + equipment $2,000 = Things owed, capital $10,000

Transaction 3
On 10/1/2013, the business purchases goods for resale for $5,000 on credit.
The asset of inventory increases and the liability to suppliers increases
Accounting equation:
Things owned, cash $8,000 + equipment $2,000 + inventory $5,000 = Things owed, capital $10,000 +
suppliers $5,000

Transaction 4
On 15/1/2013, sells half the goods for $4,000 on credit.
This will create a profit of 4,000 – 5,000/2 = $1,500. The profit is owed to the owners and is a liability of
the business to its owners.
We can look at the sale in two parts: earning $4,000 for a cost of 5,000/2 = 2,500.
Accounting equation:
Things owned, cash $8,000 +equipment $2,000+inventory $2,500 + due from customers
$4,000 = $16,500 = Things owed, suppliers $5,000 + capital $10,000 + profit [4,000 – 2,500] = $16,500

Transaction 5
On 31/1/2013, the suppliers are paid what they are owed and $100 is paid for rent.
The rent is an expense and decreases the profit. Paying suppliers what is owed to them has no effect on
profits.
Accounting equation:
Things owned, cash $2,900+equipment $2,000+inventory $2,500 + due from customers $4,000 =
$11,400 = Things owed, capital $10,000 + profit [4,000- 2,500 – 100 (rent)] = $11,400

Increase in Net Assets

Net assets = Total assets – Total liabilities
We can re-arrange the accounting equation to help us to calculate the total capital balance, which as we
have seen is the sum of capital introduced plus retained profit.
i.e. closing cap.= opening cap.+ retained profits.

Assets - Liabilities = Capital

Net assets = Capital
Drawings
Drawings are amounts of money taken out of a business by its owner. They reduce capital.

Question 1 (Dual effects)

Try to explain the dual effects of each of the following transactions.
a) A business receives a loan of $5,000 from its bank
b) A business pays $800 cash to purchase goods for resale
c) The proprietor of a business removes $50 from the till to buy her husband a birthday present
d) A business sells goods costing $300 at a profit of $140
e) A business repays a $5,000 bank loan, plus interest of $270

ANSWER
a) Assets (cash) increase by $5,000, liabilities (amount owed to the bank) increase by $5,000.
b) Assets (cash) decrease by $800, assets (inventory) increase by $800.
c) Assets (cash) decrease by $50, capital decreases by $50 (the proprietor has taken $50 drawings for
her personal use. In effect, the business has repaid her part of the amount it owed).
d) Assets (cash) increase by $440, assets (inventory) decrease by $300, capital (the profit earned for
the proprietor) increases by $140.
e) Assets (cash) decrease by $5,270, liabilities (the bank loan) decrease by $5,000, capital decreases by
$270 (the proprietor has made a 'loss' of $270 on the transaction).

Accounts Payable and Accounts Receivable

An account payable is a person from whom a business has purchased items and to whom a business
owes money. An account payable is a liability of the business.

A trade account payable is a person to whom a business owes money for debts incurred in the course of
trading operations. The term might refer to debts still outstanding which arise from the purchase from
suppliers of materials, components or goods for resale.

An account receivable is a person to whom the business has sold items and by whom the business is
owed money. A receivable is an asset of a business (the right to receive payment is owned by the
business).

A trade account receivable is a person who owes the business money for debts incurred in the course of
trading operations ie because the business has sold its goods or services.

Credit Transactions
Question 2 (Accounting equation)
Jackie Dixon has $2,500 of capital invested in her business. Of this, only $1,750 has been provided by
herself, the balance being provided by a loan of $750 from Barry Grant. What are the implications of this
for the accounting equation?
Hint. The answer is not necessarily clear cut. There are different ways of looking at Barry's investment.

ANSWER
We have assets of $2,500 (cash), balanced by liabilities of $2,500 (the amounts owed by the business to
Jackie and Barry).
 The $1,750 owed to Jackie clearly falls into the special category of liability labelled capital, because
it is a sum owed to the proprietor of the business.
 To classify the $750 owed to Barry, we would need to know more about the terms of his agreement
with Jackie.
 If they have effectively gone into partnership, sharing the risks and rewards of the business, then
Barry is a proprietor too and the $750 is 'capital' in the sense that Jackie's $1,750.
 If Barry has no share in the profits of the business, and can expect only a repayment of his 'loan' plus
some interest, the amount of $750 should be classified under liabilities.

Question 3
On 1 January 2013 a business had net assets of $15,000
On 31 January 2013, net assets amounted to £19,000.
No capital had been introduced in January, but the owner had made drawings of $750.
What profits were made in January?
A $4,000
B $4,750
C $3,250

Question 4
On 1 January 2013 a business had net assets of $15,000
On 31 January 2013, net assets amounted to £19,000.
Additional capital of $1,000 had been introduced in January, but the owner had made drawings of $400
What profits were made in January?
A $3,400
B $4,000
C $4,600
D $5,400

Question 5
On 1 January 2013 a business had net assets of $25,000
On 31 January 2013, net assets amounted to £23,000.
A loss of $7,000 had been made and the owner withdrew $1,000 to live on.
What additional capital was introduced to the business in January?
A $8,000
B $6,000
C $7,000
D $10,000

Question 6
On 1 January 2013 and 31 January 2013 a business had the following assets and liabilities:

No additional capital had been introduced, but the owner withdrew $800 to live on.
What profits were made in January?
A $1,000
B $5,800
C $200
D $1,800

Double Entry Book-keeping

Double entry bookkeeping requires that every transaction has two accounting entries, a debit and a
credit.
The rules of double entry state that every financial transaction gives rise to two accounting entries, one
a debit, the other a credit. It is vital that you understand this principle.

Rules of double entry:

Assets (e.g. vehicles, cash, bank, land, debtors or receivables, furniture, machinery, buildings, stock
a.k.a inventory)
An increase - Debit
A decrease – Credit
Expenses (e.g. purchases, salaries, interest, electricity, stationery, water, insurance, rent, fuel, tax
expense)
An increase – Debit
A decrease - Credit

Liabilities (e.g. loans, debentures, creditors or payables or suppliers, accruals, tax liability)
An increase - Credit
A decrease – Debit

Capital/Shareholders’ equity (Investment in the business by the owners)

An increase - Credit
A decrease – Debit

Revenue/Sales (One of the incomes of the business)

An increase – Credit
A decrease – Debit

DEBIT Examples: CREDIT Examples:

Expense — Telephone Bill Liabilities — Loans

— Rental
— Sales Returns
— Purchases
Assets — Motor Vehicles
— Bank balance
— Inventories
— Trade Receivables
— Input Sales Tax
— Trade Payables
— Output Sales Tax
— Bank overdraft
Income — Sales
— Purchase Returns
— Bank Interest received
— Discounts received

Drawing — Drawings Capital — Capital investment

s

Shortcut:

P E A R L S

P = Purchases
E = Expenses
A = Assets
R = Revenue
L = Liabilities
S = Shareholders’ equity or capital
Question 7: Double entry for cash transactions
A business has the following transactions.
(a) A cash sale (ie a receipt) of $2
(b) Payment of a rent bill totalling $150
(c) Buying some goods for cash at $100
(d) Buying some shelves for cash at $200
How would these four transactions be posted to the ledger accounts?
Solution:

Question 8 (Ledger accounts)

A business has the following transactions on 7 April 20X7.
a) A cash sale (ie a receipt) of $60
b) Payment of a rent bill totalling $4,500
c) Buying some goods for cash at $3,000
d) Buying some shelves for cash at $6,000
Required:
Draw the appropriate ledger ('T') accounts and show how these four transactions would be posted to
them.
Solution:

Question 9: Credit transactions

The following transactions have occurred.
a) The business sells goods on credit to a customer Mr A for $2,000.
b) The business buys goods on credit from a supplier B for $100.
How and where are these transactions posted in the ledger accounts?
Solution

Question 10 (Debit and credit)

Identify the debit and credit entries in the following transactions.
a) Bought a machine on credit from A, cost $8,000
b) Bought goods on credit from B, cost $500
c) Sold goods on credit to C, value $1,200
d) Paid D (a supplier) $300
e) Collected $180 from E, a customer
f) Paid wages $4,000
g) Received rent bill of $700 from landlord G
h) Paid rent of $700 to landlord G
i) Paid insurance premium $90
ANSWER
General Ledger and T – Accounts
The general ledger is where all the double entries are recorded. It contains individual accounts for a
business's assets, liabilities, capital, income and expenses. These individual accounts are also known as
ledger accounts.
Financial transactions of the business are recorded in the relevant ledger accounts. Immediately, a
business can gather information overview such as:
• Cash balance in the business from the cash ledger account
• Sales generated from the sales ledger account.

Double Entries are recorded into the ledger accounts T-Accounts. A T-Account is a graphical
representation of a ledger account.

Capital Expenditure and Revenue Expenditure

Capital expenditure is expenditure which results in the acquisition of non-current assets, or an
improvement in their earning capacity.
 Capital expenditure on non-current assets results in the appearance of a non-current asset in the
accounts of the business.
 The total amount of capital expenditure is not deducted from income in calculating the profit for an
accounting period.
 It is deemed to be expenditure that brings benefits to the business over more than one accounting
period.

Revenue expenditure is expenditure which is incurred either:

 for the purpose of the trade of the business, including expenditure classified as selling and
distribution expenses, administration expenses and finance charges; or
 to maintain the existing earning capacity of non-current assets, eg repairs to non-current assets.

Question 11: Capital or revenue

State whether each of the following items should be classified as 'capital' or 'revenue' expenditure or
income.
a) Purchase of premises
b) Solicitors' fees in connection with the purchase of premises
c) Costs of adding extra storage capacity to a mainframe computer used by the business
d) Computer repair and maintenance costs
e) Profit on the sale of an office building
f) Revenue from sales by credit card
g) Cost of new machinery
h) Customs duty charged on the machinery when imported into the country
i) 'Carriage' costs of transporting the new machinery from the supplier's factory to the premises of the
business purchasing the machinery
j) Cost of installing the new machinery in the premises of the business
k) Wages of the machine operators

ANSWER
a) Capital expenditure
b) The legal fees associated with the purchase of a property may be added to the purchase price and
classified as capital expenditure
c) Capital expenditure (enhancing an existing non-current asset)
d) Revenue expenditure
e) Capital income (net of the costs of sale)
f) Revenue income
g) Capital expenditure
h) If customs duties are borne by the purchaser of the non-current asset, they may be added to the
cost of the machinery and classified as capital expenditure
i) Similarly, if carriage costs are paid for by the purchaser of the non-current asset, they may be
included in the cost of the non-current asset and classified as capital expenditure
j) Installation costs of a non-current asset are also added to the non-current asset's cost and classified
as capital expenditure
k) Revenue expenditure

QUIZ
1. What is an asset?
2. What is a liability?
3. State the basic accounting equation.
4. What is capital?
5. What are drawings? Where do they fit in the accounting equation?
6. What is the main difference between a cash and a credit transaction?
7. What is an account payable? What is an account receivable?
8. Define double entry bookkeeping.
9. What is the double entry when goods are sold for cash?
10. What is the double entry when goods are purchased on credit?
11. Distinguish between capital expenditure and revenue expenditure.
ANSWERS
1. An asset is something valuable which a business owns or has the use of.
2. A liability is something which is owed to someone else.
3. Assets = Capital + Liabilities.
4. Capital is the investment of funds with the intention of earning a profit.
5. Drawings are the amounts of money taken out of a business by its owner. In the accounting
equation drawings are a reduction of capital.
6. The main difference between a cash and a credit transaction is simply a matter of time – cash
changes hands immediately in a cash transaction, whereas in a credit one it changes hands some
time after the initial sale/purchase takes place.
7. An account payable is a person from whom a business has purchased items and to whom it owes
money. An account receivable is a person to whom the business has sold items and by whom it is
owed money.
8. Double entry bookkeeping is a system of accounting which reflects the fact that every financial
transaction gives rise to two equal accounting entries, a debit and a credit.
9. Debit Cash, Credit Sales.
10. Debit Purchases, Credit Payables account.
11. Capital expenditure results in an increase in non-current assets. Revenue expenditure is trading
expenditure or expenditure in maintaining non-current assets, which has an impact on the profit or
loss for the accounting period.