THE ACCOUNTING EQUATION/BALANCE
SHEET EQUATION
A business
owns properties. These properties are called assets. The assets are the
business resources that enable it to trade and carry out trading. They are
financed or funded by the owners of the business who put in funds.
These funds,
including assets that the owner may put is called capital. Other persons
who are not owners of the firm may also finance assets. Funds from these
sources are called liabilities.
The total
assets must be equal to the total funding i.e. both from owners and non-owners.
This is expressed inform of accounting equation which is stated as follows:
ASSETS = LIABILITIES + CAPITAL
Each item in
this equation is briefly explained below.
Assets:
An asset is a resource controlled by a
business entity/firm as a result of past events for which economic benefits are expected to flow to the firm.
An
example is if a business sells goods on credit then it has an asset called a
debtor. The past event is the sale on credit and the resource is a debtor. This
debtor is expected to pay so that economic benefits will flow towards the firm
i.e. in form of cash once the customers pays.
Assets are classified into two main types:
i)
Non current
assets (formerly called fixed assets).
ii)
Current
assets.
Non
current assets are acquired by the business to assist in earning revenues and
not for resale. They are normally expected to be in business for a period of
more than one year.
Major
examples include:
§ Land
and buildings
§ Plant
and machinery
§ Fixtures,
furniture, fittings and equipment
§ Motor
vehicles
Current
assets are not expected to last for more than one year. They are in most cases directly related to
the trading activities of the firm. Examples include:
§ Stock
of goods – for purpose of selling.
§ Trade
debtors/accounts receivables – owe the business amounts as a resort of trading.
§ Other
debtors – owe the firm amounts other than for trading.
§ Cash
at bank.
§ Cash
in hand.
Liabilities:
These
are obligations of a business as a result of past events settlement of which is
expected to result to an economic outflow of amounts from the firm. An example
is when a business buys goods on credit, then the firm has a liability called
creditor. The past event is the credit purchase and the liability being the
creditor the firm will pay cash to the creditor and therefore there is an out
flow of cash from the business.
Liabilities
are also classified into two main classes.
i)
Non-current
liabilities (or long term liabilities)
ii)
Current
liabilities.
Non-current
liabilities are expected to last or be paid after one year. This includes long-term loans from banks or
other financial institutions. Current
liabilities last for a period of less than one year and therefore will be paid
within one year. Major examples:
§ Trade
creditors/
or
accounts payable – owed amounts as a result of
business buying goods on credit.
§ Other
creditors - owed amounts for
services supplied to the firm
other than goods.
§ Bank
overdraft - amounts advanced by the
bank for a short-term
period.
Capital:
This is the residual amount on the owner’s
interest in the firm after deducting liabilities from the assets.
The Accounting equation can be expressed
in a simple report called the Balance Sheet. The basic format is as follows:
Name
Balance sheet
as at 31.12.
Sh Sh
Sh Sh
Capital xx Non Current Assets
Land & Buildings xx
Non
Current Liabilities Plant & Machinery xx
Loan xx Fixtures, furniture
& fittings xx
Motor vehicles xx
Current
liabilities
xx
Overdraft xx Current
Assets
Creditors xx xx Stocks xx
Debtor’s
xx
Capital and
Liabilities Cash at bank xx
Cash in hand xx xx
xx
Total assets xx
The above
format of the balance sheet is the horizontal format however currently the
practice is to present the Balance Sheet using the vertical format which is
shown below.
Name
Balance sheet
as at 31.12.
Non Current
Assets Sh Sh Sh
Land &
Buildings xx
Plant &
Machinery xx
Fixtures,
furniture & fittings xx
Motors
vehicles xx
xx
Current Assets
Stocks/inventories xx
Debtors/ trade
receivables xx
Cash at bank xx
Cash in hand xx
Current
Liabilities
Bank Overdraft xx
Creditors/trade
payables xx (xx)
Net Current
Assets xx
Net assets xx
Capital xx
Non Current
Liabilities
Loan (from
bank or other sources) xx
xx
Please pay
attention to the format. The Non Current assets are listed in order of
permanence as shown i.e. from Land and Buildings to motor vehicles. The Current Assets are listed in order of
liquidity i.e. which asset is far from being converted into cash. Example
,stock is not yet sold, (i.e. not yet realised yet) then when it is sold we
either get cash or a debtor (if sold on credit). When the debtor pays then the debtor may pay
by cheque (cash has to be banked) or cash.
The Current
Liabilities are listed in order of payment i.e. which is due for payment
first. Bank overdraft is payable on
demand by the bank, then followed by creditors.
Note that in
the vertical format, current liabilities are deducted from current assets to
give net current assets. This is added
to Non Current assets, which give us net assets.
Net assets
should be the same as the total of Capital and Non Current Liabilities.
No comments:
Post a Comment