Cambridge IGCSE Accounting · 0452
Chapter 1: The Fundamentals of Accounting — Part 2
Section 1.2 · The Accounting Equation
The accounting equation is the cornerstone of the entire financial accounting system. It represents the relationship between what a business owns and who provided the resources to buy those things.
Core Definitions and Classification
You must memorise these definitions using Cambridge terminology and be able to classify items correctly:
- Assets
- The resources owned and used within the business (e.g., machinery, inventory, cash, trade receivables).
- Liabilities
- The amount of money owing to external parties (firms or people outside the business) for the use of their resources (e.g., bank loans, trade payables).
- Owner’s Equity (Capital)
- The amount of resources supplied by the owner to the business. It represents the owner’s “net worth” or “interest” in the firm.
Classification Drill
| Item | Classification | Reason |
|---|---|---|
| Inventory held for resale | Asset | Resource owned by the business |
| Bank loan (repayable in 5 years) | Liability | Money owed to an external party |
| Trade payables (amount owed to suppliers) | Liability | Owed to external suppliers |
| Cash introduced by the owner | Owner’s Equity | Resources supplied by the owner |
| Drawings (owner takes cash for personal use) | Reduces Owner’s Equity | Not an expense — reduces capital directly |
The Equation
The equation must always balance because every resource in the business is supplied by either the owner or an outside party.
Assets = Owner’s Equity (Capital) + Liabilities
Equation Rearrangements:
- Owner’s Equity = Assets − Liabilities
- Liabilities = Assets − Owner’s Equity
The Effect of Profit, Loss, and Drawings on Capital
At the end of a financial period, the Owner’s Equity (Capital) figure changes based on the business’s performance and the owner’s personal actions.
- Profit: Increases capital because it is the reward for the owner’s investment.
- Loss: Decreases capital because the owner’s investment has been “used up” by expenses exceeding revenue.
- Drawings: Occurs when the owner takes cash or inventory for personal use. This decreases capital.
The Calculation of New Capital:
New Capital = Opening Capital + Profit for the Year − Drawings
(If there is a loss, you subtract it instead of adding profit).
Worked Example: Applying the Equation
Scenario: On 1 January, a business has:
- Fixtures: $10,000
- Inventory (Stock): $7,000
- Cash at Bank: $3,000
- Trade Payables (Creditors): $2,000
By 31 January, the position changes:
- Fixtures: $10,000
- Inventory: $0
- Cash at Bank: $14,000
- Trade Payables: $2,000
Step 1: Calculate Opening Capital (1 January)
Assets = 10,000 + 7,000 + 3,000 = $20,000
Liabilities = $2,000
Capital = 20,000 − 2,000 = $18,000
Step 2: Calculate Closing Capital (31 January)
Assets = 10,000 + 0 + 14,000 = $24,000
Liabilities = $2,000
Capital = 24,000 − 2,000 = $22,000
Step 3: Calculate Profit for the month
Profit = Closing Capital − Opening Capital
Profit = 22,000 − 18,000 = $4,000
Explanation: Inventory ($7,000) was sold for $14,000 cash. The $7,000 cost of inventory left the business, but $14,000 cash came in — a net asset increase of $7,000. Combined with unchanged liabilities, capital rose by $4,000 (the profit).
Worked Example 2: Transaction Effects on the Equation
Starting position: Assets $50,000 = Owner’s Equity $30,000 + Liabilities $20,000
Transaction A: The owner takes $3,000 cash for personal use (drawings).
- Assets (Cash) decrease by $3,000 → Assets now $47,000
- Owner’s Equity decreases by $3,000 → Equity now $27,000
- Liabilities unchanged at $20,000
- Check: $47,000 = $27,000 + $20,000 ✓
Transaction B: The business buys equipment for $8,000 on credit from a supplier.
- Assets (Equipment) increase by $8,000; Assets now $55,000
- Liabilities (Trade Payables) increase by $8,000; Liabilities now $28,000
- Owner’s Equity unchanged at $27,000
- Check: $55,000 = $27,000 + $28,000 ✓
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