Chapter 2: The Accounting Equation

Question 1

What is the accounting equation?

Answer 1

assets = opening capital + profits - drawings + liabilities`

Question 2

What is the purpose of the financial statement that lists an entity’s total assets and total capital/liabilities?

Answer 2

The financial position of the entity at a particular moment in time.

Question 3

Which elements of the accounting equation change when a sole trader purchases goods on credit?

Answer 3

Assets will increase as the sole trader has acquired inventory and liabilities will increase as the goods were purchased on credit

Question 4

Which elements of the accounting equation change when a sole trader who has an overdrawn bank balance receives cash from a credit customer?

Answer 4

Assets and liabilities: the overdrawn liability will decrease and receivables will decrease by an equal amount.

Question 5

Which elements of the accounting equation change when a sole trader borrows money from a bank?

Answer 5

Assets increase as cash on receipt of the loan funds, and liabilities increase as the loan is a liability

Question 6

Which elements of the accounting equation change when a sole trader sells goods for more cash than they bought them for?

Answer 6

Assets will increase as cash increases more than inventory decreases, and capital will increase due to the profit

Question 7

What are the elements of financial statements, as identified by the IASB’s Conceptual Framework?

Answer 7

Income, expenses, equity

Question 8

Define: Asset

Answer 8

The Conceptual Framework states than an asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity. Assets are key elements of financial statements.

Question 9

Examples of assets (7)

Answer 9

1. Land and buildings
2. Motor vehicles
3. Plant and machinery
4. Fixtures and fittings
5. Cash
6. Inventory
7. Receivables

Question 10

Define: Liability

Answer 10

The Conceptual Framework states that a liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities are key elements of financial statements.

Question 11

Examples of liabilities (4)

Answer 11

1. Bank Loan
2. Overdraft
3. Payables
4. Taxation

Question 12

Define: Business entity concept

Answer 12

A business is a separate entity from its owner

Question 13

Define: Capital

Answer 13

The Conceptual Framework states that capital (equity) is the residual interest in the assets of the entity after deducting all its liabilities. Equity is a key element of financial statements

Question 14

Define: Accounting equation (simple)

Answer 14

assets = capital + liabilities

Question 15

Define: Historical cost

Answer 15

Transactions are recorded at their cost when they were incurred

Question 16

Define: Profit

Answer 16

The excess of income over expenses

Question 17

Define: Loss

Answer 17

The excess of expenses over income

Question 18

Define: Income

Answer 18

Increases in economic benefit over a period in the form of inflows or increases of assets, or decreases of liabilities, resulting in increases in equity/capital. It can include both revenue and gains. Income is a key element of financial statements.

Question 19

Define: Expenses

Answer 19

Decreases in economic benefits over a period in the form of outflows or depletion of assets, or increases in liabilities, resulting in decreases in equity/capital. Expense is a key element of financial statements.

Question 20

Define: Drawings

Answer 20

Money and goods taken out of a business by its owner

Question 21

Define: Creditor

Answer 21

Party to whom a business owes money

Question 22

Define: Trade payables

Answer 22

The amounts due to credit suppliers

Question 23

Define: Debtor

Answer 23

Party who owes money to the business

Question 24

Define: Trade receivables

Answer 24

The amounts owed by credit customers

Question 25

What is the accruals concept?

Answer 25

The accruals concept requires that income earned is matched with the expenses incurred in earning it

Question 26

Define: Net assets

Answer 26

Assets less liabilities

Question 27

Define: Non-current assets

Answer 27

Assets acquired for continuing use within the business, with a view to earning income or making profits from their use, either directly or indirectly, over more than one reporting period

Question 28

Examples of non-current assets

Answer 28

1. Property, plant, and equipment
2. Intangible non-current assets, e.g. goodwill
3. Long-term investments

Question 29

Which is the only non-current asset that does not depreciate?

Answer 29

Freehold land

Question 30

Define: Current assets

Answer 30

An asset is current when it is expected to be realised in, or intended for sale or consumption in, the entity’s normal operating cycle, or it is held for being trader, or it is expected to be realised within 12 months of the date of the statement of financial position, or it is cash or a cash equivalent

Question 31

Examples of current assets (5)

Answer 31

1. Cash
2. Trade and other receivables
3. Inventory
4. Prepayments
5. Short-term investments

Question 32

Define: Non-current liabilities

Answer 32

A debt which is not payable within one year. Any liability which is not current must be non-current

Question 33

Examples of non-current liabilities (2)

Answer 33

1. Loans which are not repayable for more than one year

2. Loan stock or debentures

Question 34

Define: Current liabilities

Answer 34

Debts of the business that must be paid within one year, or within the entity’s normal operating cycle, or that are held to be traded

Question 35

Examples of current liabilities (5)

Answer 35

1. Loans repayable within one year
2. Bank overdraft
3. Trade and other payables
4. Taxation
5. Accruals

Question 36

Define: Gross profit

Answer 36

Revenue from sales, less cost of sales

Question 37

Define: Profit for the period

Answer 37

Gross profit less expenses plus non-trading income

Question 38

Calculate: Gross profit margin

Answer 38

(gross profit/revenue) x 100

Question 39

Examples of distribution costs (3)

Answer 39

1. Salaries, wages, and sales commission of employees
2. marketing costs
3. The costs of running and maintaining delivery vans, including depreciation on these and any losses on their disposal

Question 40

Examples of administrative costs (8)

Answer 40

1. Management and office staff salaries
2. Rent and local business or property taxes
3. Insurance
4. Telephone and postage
5. Printing and stationery
6. Heating and lighting
7. Irrecoverable debts written off
8. The cost of running and maintaining other non-current assets such as office buildings, plus depreciation and losses on disposal of these

Question 41

Examples of finance costs (2)

Answer 41

1. Interest on loans

2. Bank overdraft interest

Question 42

Examples of income from other sources (4)

Answer 42

1. Profit on disposals of non-current assets
2. Dividends or interest received from investments
3. Rental income from property owned but not otherwise used by the business
4. Amounts due in respect of insurance claims