Accounting Fundamentals and the Accounting Equation
What the exam tests
This domain tests classification of assets, liabilities and capital, and whether you can prove the accounting equation after a series of transactions. Expect opening-position questions, transaction effects and the distinction between capital and revenue items.
Core rules
- The accounting equation is Assets = Liabilities + Capital. The expanded form is Assets = Liabilities + Opening capital + Profit - Drawings.
- Assets are resources controlled by the business; liabilities are present obligations; capital is the owner's residual interest.
- The business entity concept keeps owner's personal items out of the business records. Drawings reduce capital; they are not an expense.
- Duality means every transaction affects at least two elements, keeping the equation balanced.
Worked example
A sole trader starts with 10,000 cash invested and buys equipment for 3,000 on credit. Assets are cash 10,000 + equipment 3,000 = 13,000. Liabilities are 3,000. Capital is 10,000. The equation is 13,000 = 3,000 + 10,000. If the trader later pays the supplier 1,000 cash, assets become 12,000, liabilities become 2,000 and capital remains 10,000; the equation still balances at 12,000 = 2,000 + 10,000.
Traps
Do not treat a bank loan received as income: it increases cash and a liability. Do not treat loan repayment as an expense: the principal reduces the liability, while only interest is an expense. Do not include the owner's private car or household bills unless they are genuinely business transactions, and record private withdrawals as drawings.
Key points
- Prove the equation after every transaction, not just at the start.
- Profit increases capital; drawings and losses reduce it.
- Capital introduced is not revenue.
- Keep business and personal affairs separate.