BF 120 Accounting Equation

BASIC ELEMENTS OF FINANCIAL POSITION
The Accounting Equation
The financial condition or position of a business enterprise is represented by

the relationship of assets to liabilities and capital.
Assets
Assets are properties that are owned and have money value.
For instance
 Cash
 Inventory
 Buildings
 equipment.

Liabilities
Liabilities are amounts owed to outsiders, such as:
 Notes payable – these are written agreements (promissory notes) in

which one party agrees to pay the other party a certain amount of
cash.
 accounts payable
 bonds payable.
Capital
 This is the interest of the owners in an enterprise, also known as owners’

equity.
These three basic elements are connected by a fundamental relationship

called the accounting equation. This equation expresses the equality of the
assets on one side with the claims of the creditors and owners on the other
side:
Assets = Liabilities + Owner’s Equity
Take note that the accounting equation of the business should always
balance after every transaction.
1
Example 1.
During the month of January, Mr. Patrick Inambawo, lawyer,
1. Invested K5, 000 to open his law practice.

2. Bought office supplies on account, K500.
3. Received K2, 000 in fees earned during the month.
4. Paid K100 on the account for the office supplies.
5. Withdrew K500 for personal use.
TYPES OF BUSINESS ORGANIZATIONS
A business can have one of three forms of organization:
 Proprietorship
 partnership
 or corporation.
You should understand the differences among the three.
PROPRIETORSHIPS
 A proprietorship has a single owner, called the proprietor, who is often the
manager.
 Proprietorships tend to be small retail stores or professional businesses,
such as physicians, attorneys, and accountants.
 From the accounting viewpoint, each proprietorship is distinct from its
proprietor
 The accounting records of the proprietorship do not include the
proprietor’s personal financial records.
 However, from a legal perspective, the business is the proprietor.
PARTNERSHIPS
 A partnership joins two or more individuals as co-owners.
 Each owner is a partner.
 Many retail establishments and professional organizations of physicians,
attorneys, and accountants are partnerships.
 Most partnerships are small or medium-sized, but some are huge,
exceeding 2,000 partners.
2
 Accounting treats the partnership as a separate organization, distinct
from the personal affairs of each partner.
 From a legal perspective, a partnership is the partners.
CORPORATIONS
 A corporation is a business owned by stockholders, or shareholders.
 These are the people who own shares of ownership in the business.
 A business becomes a corporation when the state approves its articles of
incorporation.
 A corporation is a legal entity that conducts business in its own name.
 Unlike the proprietorship and the partnership, the corporation is not
defined by its owners. Corporations differ significantly from
proprietorships and partnerships in another way.
 If a proprietorship or a partnership cannot pay its debts, lenders can take
the owners’ personal assets—their cash—to satisfy the business’s
obligations.
 But if a corporation goes bankrupt, lenders cannot take the personal
assets of the stockholders.
 This limited liability of stockholders for corporate debts explains why
corporations are so popular
 People can invest in corporations with limited personal risk.
 Another factor in corporate growth is the division of ownership into
individual shares. The Coca-Cola Company, for example, has billions of
shares of stock owned by many stockholders. An investor with no
personal relationship to Coca-Cola can become a stockholder by buying
50, 100, 5,000, or any number of shares of its stock.
3
THE DOUBLEENTRY SYSTEM
Preparing a new equation A = L + C after each transaction would be

cumbersome and costly, especially when there are a great many
transactions in an accounting period.
Also, information for a specific item such as cash would be lost as

successive transactions were recorded. This information could be obtained
by going back and summarizing the transactions, but that would be very
time-consuming. Thus we begin with the account.
The Account
An account may be defined as a record of the increases, decreases, and

balances in an individual item of asset, liability, capital, income (revenue), or
expense.
The simplest form of the account is known as the “T” account because it
resembles the letter “T.” The account has three parts:
1. the name of the account and the account number

2. the debit side (left side), and
3. The credit side (right side).
The increases are entered on one side, the decreases on the other. The
balance (the excess of the total of one side over the total of the other) is
inserted near the last figure on the side with the larger amount.
Debits and Credits
When an amount is entered on the left side of an account, it is a debit, and

the account is said to be debited.
When an amount is entered on the right side, it is a credit, and the account
is said to be credited.
The abbreviations for debit and credit are Dr. and Cr. respectively.
Whether an increase in a given item is credited or debited depends on the

category of the item. By convention, asset and expense increases are
4
recorded as debits, whereas liability, capital, and income increases are
recorded as credits.
Asset and expenses decreases are recorded as credits, whereas liability,

capital, and income decreases are recorded as debits.
The following tables summarize the rule.
ASSETS AND EXPENSES LIABILITIES, CAPITAL AND

INCOMES
Dr Cr Dr Cr
+ - - +
Increase Decrease Decrease Increase
An account has a debit balance when the sum of its debits exceeds the sum
of its credits;
An account has a credit balance when the sum of the credits is the greater.
In double-entry accounting, which is in almost universal use, there are equal

debit and credit entries for every transaction. Where only two accounts are
affected, the debit and credit amounts are equal. If more than two accounts
are affected, the total of the debit entries must equal the total of the credit
entries.
Worked examples
1. The owner starts the business with K10,000 in cash on 1 August 2018.
2. A van is bought for K4,500 cash on 2 August 2018.
3. Fixtures (e.g. shelves) are bought on credit from Shop Fitters for
K1,250 on 3 August 2018.
End

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BASIC ELEMENTS OF FINANCIAL POSITION

The Accounting Equation

The financial condition or position of a business enterprise is represented by

Liabilities are amounts owed to outsiders, such as:

 Notes payable – these are written agreements (promissory notes) in

 This is the interest of the owners in an enterprise, also known as owners’

These three basic elements are connected by a fundamental relationship

Assets = Liabilities + Owner’s Equity

During the month of January, Mr. Patrick Inambawo, lawyer,

1. Invested K5, 000 to open his law practice.

TYPES OF BUSINESS ORGANIZATIONS

A business can have one of three forms of organization:

You should understand the differences among the three.

Preparing a new equation A = L + C after each transaction would be

Also, information for a specific item such as cash would be lost as

An account may be defined as a record of the increases, decreases, and

1. the name of the account and the account number

Debits and Credits

When an amount is entered on the left side of an account, it is a debit, and

Whether an increase in a given item is credited or debited depends on the

Asset and expenses decreases are recorded as credits, whereas liability,

The following tables summarize the rule.

ASSETS AND EXPENSES LIABILITIES, CAPITAL AND

In double-entry accounting, which is in almost universal use, there are equal

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