Chapter 2 The accounting equation

Question 1

1.1 Statement of financial position

Answer 1

The accounting equation is also known as the statement of financial position equation (STP). This is an expansion of the equation showing assets, liabilities, and capital.
Assets have two classifications current and non-current. Current assets are acquired for resale or expected to be realised within the normal course of trading (stock, cash). Non-current assets are acquired for on-going long term use in business (land, buildings, plant, and machinery).
Liabilities have two classifications current and non-current. Current liabilities are payable within 12 months of the statement of financial position date (money owned to suppliers). Non-current are long term liabilities payable more than 12 months after the accounts date (loan).

Question 2

1.2 The business entity concept

Answer 2

This concept states the accounts should only show the activities of the business and not personal activities of its owners. The business entity is separate from its owners, any flows of money between the owner and the business such as extra invested capital and drawings are reporting within the statement of financial position as capital.

Question 3

1.3 Sole trader capital

Answer 3

This is how much the business owns back to the owner, the calculation of yearend capital is:
Opening capital + net profit + capital injections – drawings = closing capital
The capital within a company is shown in a different way to sole traders.

Question 4

1.4 the accounting equation

Answer 4

A consequence of the business entity concept is that a business will buy assets using borrowed funds or capital from its owner, therefore the accounting equation (assets = liabilities + capital) always holds true.
Capital is how much the business owes the owner (opening capital + profit + capital injection – drawings), so assets – liabilities = opening capital + profit + capital injections - drawings

Question 5

2.1 Duality concept

Answer 5

The duality concept states every transaction has a dual effect (2 impacts). For example, if a company purchase goods on credit it increases trade payables and increases inventory.
Inventory and duality concept: businesses initially record inventory as an asset at how much it cost. If the business sells inventory for higher than cost, the business makes a profit which increase capital. If the business sells inventory for less than cost, the business makes a loss which reduces capital.

Question 6

3.1 The statement of profit or loss

Answer 6

The statement of profit or loss shows how the profit figure included in the calculation of capital has arisen. It shows income less expenses over a period of time (usually a year). if expenses are more than income it will report a loss.
Revenue: there are two types of sales, cash sales (increase cash) and credit sales (allow customers to pay later and will increase trade receivables).
Cost of sales: calculated as opening inventory + purchases – closing inventory.
Purchases: there are two types of purchases, cash purchases (decrease cash) and credit purchases (increase trade payables)
Expenses: there are the running costs of the business and will reduce profits which reduces capital. With sole trader accounts, all different types of expenditure are includes as separate figures on the SPL.