Introduction to Accounting and the Accounting Equation
Introduction to Accounting and the Accounting Equation
This domain tests why accounting information is prepared and how the accounting equation absorbs everyday transactions. SPM items often require the effect on assets, liabilities and capital, not only a revised total.
Core rules
- Accounting supplies financial information to owners, lenders, suppliers, employees and tax authorities.
- The basic equation is Assets = Capital + Liabilities. Capital is the owner's residual claim; liabilities are outside claims.
- Expanded: Assets = Opening capital + Profit - Drawings + Liabilities.
- Every transaction has at least two effects and keeps the equation balanced.
- Capital introduced increases assets and capital. Drawings reduce assets and capital. Revenue increases profit and capital; expenses reduce them.
Worked example
A trader starts with RM20,000 cash. She buys equipment for RM6,000 cash, buys inventory RM3,000 on credit, then pays the supplier RM1,000.
- Cash RM20,000; capital RM20,000: assets RM20,000 = capital RM20,000.
- Equipment +RM6,000, cash -RM6,000: assets remain RM20,000.
- Inventory +RM3,000, trade payable +RM3,000: assets RM23,000 = capital RM20,000 + liabilities RM3,000.
- Cash -RM1,000, trade payable -RM1,000: assets RM22,000 = capital RM20,000 + liabilities RM2,000. Each step leaves the equation balanced.
Traps
- Treating a bank overdraft as an asset; it is a liability.
- Recording the owner's personal payment as a business expense instead of drawings.
- Putting profit in a liability account; profit belongs to capital.
- Confusing inventory purchases with purchases of non-current assets.
Key points
- Assets = Capital + Liabilities
- Profit and drawings adjust capital
- Overdraft is a liability
- Drawings are not expenses
- Dual effect keeps the equation balanced