Chapter 2: The accounting equation

Question 1

What is the accounting equation?

What is another name for the accounting equation?

Answer 1

Accounting equation: assets = capital + liabilities

This is also known as the balance sheet equation.

Question 2

Define the following key terms:

Profit
Loss
Income
Expenses

Answer 2

Profit: The excess of income over expenses.
Loss: The excess of expenses over income.
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.’ It can include both revenue and gains.
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.’

Question 3

How do profits and losses affect owners capital?

Answer 3

Profits are added to owner’s capital
Losses are deducted from owner’s capital

Question 4

Define drawings.

Answer 4

Drawings: 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.

It is important to remember that any assets taken from a business by its owner are classified as drawings. The information in a question may not always refer to the term drawings, but you are expected to read the information carefully to determine that the owner has extracted assets and therefore such a transaction should be recorded as drawings.