Owner's Equity, Drawings and a Bank Loan
On 1 March 2025, Kaanu Traders, a sole trader, had equipment $48,000, inventory $22,000 and a bank balance of $15,000. Trade payables were $9,000. During March, the owner took goods costing $1,800 (selling price $2,500) for family use. The business paid $12,000 on 1 March for a one-year insurance policy beginning that day and covering 1 March 2025 to 28 February 2026. It also received a $20,000 bank loan repayable in three years; the money was paid into the business bank account. No other transactions occurred. The owner believes the loan increases capital because the bank balance rises, and that drawings should be recorded at selling price because that is what the goods would have fetched. He also thinks the insurance payment is an asset because it was paid in one amount.
1. Calculate Kaanu Traders' capital on 1 March 2025 using the accounting equation, and state the revised capital after the three March transactions. Show your workings.
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Accounting equation at 1 March 2025
| Item | $ |
|---|---|
| Equipment | 48,000 |
| Inventory | 22,000 |
| Bank | 15,000 |
| Total assets | 85,000 |
| Trade payables | (9,000) |
| Capital | 76,000 |
Check: Assets = Capital + Liabilities: 85,000 = 76,000 + 9,000.
After the three March transactions
- Drawings of goods: inventory falls by cost 1,800 and capital falls by 1,800. The selling price of 2,500 is not used because the business has made no sale and prudence prevents anticipating profit.
- Insurance: bank falls by 12,000; prepaid insurance of 11,000 is an asset at 31 March; one month's expense (1,000) reduces capital.
- Loan: bank rises by 20,000 and a liability rises by 20,000; capital is unchanged because the business owes the money back.
Revised capital = 76,000 − 1,800 − 1,000 = 73,200. This can be checked: assets = 48,000 + 20,200 + 23,000 + 11,000 = 102,200; liabilities = 9,000 + 20,000 = 29,000; capital = 102,200 − 29,000 = 73,200.
2. Explain whether the owner's treatment of the loan and drawings is acceptable. Refer to the business entity and accrual concepts.
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Loan: The owner's view is not acceptable. Under the business entity concept the loan is a liability of the business, not capital. The bank balance increases, but so does the obligation to repay; there is no increase in owner's equity. It is repayable in three years, so it is a non-current liability unless an instalment falls due within 12 months.
Drawings: Recording drawings at selling price is not acceptable. Drawings are measured at cost of the goods taken, 1,800. Using 2,500 would record a profit that has not been earned and would overstate the owner's withdrawal. The accounting equation effect is a reduction in inventory and capital of 1,800.
Insurance: The payment is not wholly an asset. Under the accrual concept, only the unexpired portion is an asset; the expired portion is an expense. At 31 March 2025, 11 months remain unexpired, so 11,000 is prepaid and 1,000 is an expense.
3. State the balances to appear in the balance sheet at 31 March 2025 for bank, prepaid insurance and the loan, and classify the loan.
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At 31 March 2025:
- Bank: 15,000 − 12,000 + 20,000 = $23,000 debit.
- Prepaid insurance: 12,000 × 11/12 = $11,000 current asset.
- Loan: $20,000 liability; classified as non-current because it is repayable in three years and no part is due within 12 months.
- Inventory: 22,000 − 1,800 = $20,200.
These balances support the revised capital of 73,200: assets 48,000 + 20,200 + 23,000 + 11,000 = 102,200; liabilities 9,000 + 20,000 = 29,000.