Financial Accounting Fundamentals and the Accounting Equation
The accounting equation is the foundation of the statement of financial position: Assets = Capital + Liabilities. Capital (owner's equity) is the owner's claim on the business; it rises with capital introduced and profit, and falls with drawings and losses. Every transaction has a dual effect, so the equation stays in balance.
Core rules
- Assets are resources controlled by the business (cash, inventory, equipment, receivables).
- Liabilities are present obligations (payables, bank loan, accruals).
- Capital is the residual interest: Capital = Assets - Liabilities.
- Profit increases capital; drawings reduce it. Drawings are not an expense.
Worked example
A sole trader starts with €10,000 in the bank. She buys equipment for €3,000 cash and inventory for €2,000 on credit. She then sells goods costing €500 for €800 on credit.
- After the first transactions: assets = bank €7,000 + equipment €3,000 + inventory €2,000 = €12,000; liabilities = €2,000; capital = €10,000. Check: 12,000 = 10,000 + 2,000.
- Sale: inventory falls by €500, receivables rise by €800, and profit of €300 increases capital. Assets = 7,000 + 3,000 + 1,500 + 800 = €12,300; liabilities €2,000; capital €10,300. Check: 12,300 = 10,300 + 2,000.
Traps
Treating drawings as an expense; recording a purchase of inventory as an asset when it has been sold; omitting the profit element in a credit sale; and mixing business and personal cash. In exam calculations, always test the equation after adjustments.