2. The Accounting Equation Flashcards
What is the accounting equation?
Accounting equation: assets = capital + liabilities
What is Capital?
In accounting, capital is an investment of money (funds) with the intention of earning a return.
A business owner invests capital with the intention of earning a profit. As long as that money is invested, accountants will treat the capital as money owed to the owner by the business.
Where do profits/losses fit into the accounting equation?
Profits are added to the owner’s capital.
So long as the business retains the profits and does not pay anything out to its owner, the retained profits are accounted for as an addition to the owner’s capital.
Define profit.
Profit: The excess of income over expenses.
Define loss.
The excess of expenses over income.
Define Income.
Income is ‘increases in assets or decreases in liabilities that result in increases in equity (capital), other than those relating to contributions from holders of equity claims.’ (Conceptual Framework: para. 4.68) It can include both revenue and gains.
Define Expenses.
Expenses are ‘decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims.’ (Conceptual Framework: para. 4.69)
How do profits and losses affect owner’s capital?
What are the elements of financial statements?
Profits are added to owner’s capital.
Losses are deducted from owner’s capital.
The conceptual framework identifies income and expenses, and assets, liabilities and equity, as the elements of financial statements. Each element represents a class of transactions or other events that are grouped together according to their economic characteristics.
Define Drawings.
How are drawings of particular relevance to sole traders?
Drawings are money and goods taken out of a business by its owner.
The owner of a sole tradership does not get paid a wage; they ‘draw out’ or appropriate some of their capital as drawings.
How would the owner of a sole trader paying themselves a wage appear in the financial statements of a sole tradership?
The wage is not an expense to be deducted in arriving at the figure of net profit because any amounts paid by a business to its owner are treated by accountants as withdrawals or appropriations of profit and not as expenses incurred by the business.
