Chapter 2 - The Accounting Equation

Question 1

What is an asset?

Answer 1

An asset is a ‘present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits.’ (Conceptual Framework: paras. 4.3 and 4.4)

Assets may be held for use in the long-term (non-current assets) or for the short term as trading assets (current assets).

A non-current asset is acquired for long term use in the business, with a view to earning profits from its use, either directly or indirectly.

Non-current assets may be tangible (with a physical reality) or intangible.

Current assets are either cash or items which are held by the entity to be turned into cash shortly.

Question 2

What is a liability?

Answer 2

A liability is a ‘present obligation of the entity to transfer an economic resource as a result of past events.’ (Conceptual Framework: para. 4.26)

Liabilities may also be current (economic resources expected to be transferred in the next 12 months) or non-current (economic resources expected to be transferred in more than 12 months).

Non-current liabilities are payable after one year, such as secured loans.

Current liabilities are payable within one year, such as trade payables and bank overdrafts.

Question 3

What is the accounting equation?

Answer 3

Accounting equation: assets = capital + liabilities

Question 4

Define Capital

Answer 4

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 profit. As long as that money is invested, accountants will treat the capital as money owed to the owner by the business.

Capital comprises opening capital + capital introduced + profits – losses – drawings of capital/profits taken by the owners.

Question 5

Define Loss (1)

Answer 5

Loss: The excess of expenses over income.
Losses are deducted from owner’s capital

Question 5

Define Profit (1)

Answer 5

Profit: The excess of income over expenses.
Profits are added to owner’s capital

Question 6

Define Income (1)

Answer 6

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.

Question 7

Define Expenses (1)

Answer 7

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)

Question 8

Define Drawings (1)

Answer 8

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.

Question 9

Define Creditor (1) and Trade payable (1)

Answer 9

Creditor: A party (normally an individual, another business or a financial institution) to whom a business owes money.

A trade creditor is a party to whom a business owes money for trading debts. In the accounts of a business, debts still outstanding which arise from the purchase from suppliers of materials, components or goods for resale are called trade payables.

Trade payables: The amounts due to credit suppliers.

Question 10

What is the accruals concept?

Answer 10

The accruals (or matching) concept requires that income earned is matched with the expenses incurred in earning it.

Question 11

Define Debtor (1) and Trade receivable (1)

Answer 11

Debtor: A party who owes money to the business.

In the accounts of the business, amounts owed by debtors are called trade receivables.
A trade receivable is an asset of a business. When the debt is finally paid, the receivable ‘disappears’ as an asset, to be replaced by ‘cash at bank and in hand’.

Trade receivables: The amounts owed by credit customers.

Question 12

Define Net assets

Answer 12

Net assets = assets – liabilities, therefore net assets = capital.

Question 13

Statement of financial position calculation

Answer 13

The more detailed accounting equation, represented in the IAS 1 format for the statement of financial position, states that non-current assets + current assets = capital + profit – losses – drawings + non-current liabilities + current liabilities.

Question 14

What is the Gross Profit margin

Answer 14

Gross profit represents the profit made directly from the sale of goods or services. It can be represented as a percentage of revenue, called the gross profit margin.

Gross Profit margin = Gross Profit/Revenue x 100%

The gross profit margin can be used to compare the results of different periods to see how well the costs of sales are being controlled as revenue changes. It can also be used to compare the results of different businesses in the same industry.

Question 15

Define Gross profit

Answer 15

Gross profit earned on trading (revenue from sales, less cost of sales)

Gross profit is the difference between:
* the value of sales revenue; and
* the purchase or production cost of the goods sold: cost of sales.

Gross profit represents the profit made directly from the sale of goods or services. It can be represented as a percentage of revenue, called the gross profit margin.

Gross Profit margin = Gross Profit/Revenue x 100%

The gross profit margin can be used to compare the results of different periods to see how well the costs of sales are being controlled as revenue changes. It can also be used to compare the results of different businesses in the same industry.

Question 16

What are the Business expenses that appear in the statement of profit or loss

Answer 16

Business expenses not directly related to cost of sales appear in the statement of profit or loss under one of three headings:
1. Distribution costs - Expenses associated with selling and delivering goods to customers.
2. Administrative costs - Expenses of providing management and administration for the business.
3, Finance costs - Expenses associated with funding such as bank loans.

Question 17

Define business expenses - Distribution costs + examples

Answer 17

Distribution costs - Expenses associated with selling and delivering goods to customers.

For example:
* salaries, wages and sales commission of marketing and distribution staff
* marketing costs (eg, advertising and sales promotion expenses)
* the costs of running and maintaining delivery vans, including depreciation on these and any losses on their disposal

Question 18

Define business expenses - Administrative costs + examples

Answer 18

Administrative costs - Expenses of providing management and administration for the business.

For example:
* management and office staff salaries
* rent and local business or property taxes
* insurance
* cloud-accounting software fees
* printing and stationery
* heating and lighting
* irrecoverable debts written off or increases in allowance for receivables. Sometimes customers fail to pay what they owe and a business has to decide to write the debt off create an allowance in respect of the amounts that are unlikely to be collected. Bad debts and allowances for receivables are described more fully in Chapter 8.
* the cost of running and maintaining other non- current assets such as office buildings, plus depreciation and losses on disposal of these.

Question 19

Define business expenses - Finance costs + examples

Answer 19

Finance costs - Expenses associated with funding such as bank loans.

For example:
* interest on loans
* bank overdraft interest

Question 20

Layout out of SPL

Answer 20

Statement of profit or loss for the year ended 31 Dec 2024
£
Revenue X
Cost of Sales (X)
_______
Gross Proft X

Distribution Costs (X)
Administrative Costs (X)
Finance Costs (X)
Income from other sources X
_______
Net Proft X

Question 21

Layout of SOFP

Answer 21

See image