Accounting equation and account types - Assets, liabilities,...

Learning Outcomes

After studying this article, you will be able to state and apply the accounting equation, identify and classify assets, liabilities, and equity, and analyse their relationships. You will distinguish between current and non-current items, understand how profit and drawings affect equity, and explain the impact of typical transactions on the equation. This knowledge is fundamental for ACCA Maintaining Financial Records (FA2).

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you need a clear understanding of the accounting equation and how the main types of account relate to each other. This article focuses on the following key syllabus requirements:

• Explain the meaning of the accounting equation and its role in double-entry bookkeeping
• Identify and classify elements of the financial statements: assets, liabilities, equity (capital), income, and expenses
• Distinguish between current and non-current assets and liabilities
• Demonstrate how business transactions affect the accounting equation
• Explain the effect of profit, loss, and drawings on owner’s equity
• Prepare and interpret a basic statement of financial position

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Complete the accounting equation: Assets = __ + __.
2. A business buys a machine using a long-term bank loan. Which items in the accounting equation increase?
3. Which of the following is a non-current liability? a) Overdraft
   b) Trade payables
   c) Bank loan (repayable in 3 years)
   d) Inventory
4. True or false? Drawings by the owner increase expenses in the statement of profit or loss.
5. If a business earns a profit, which component of equity is directly affected?

Introduction

The accounting equation is the basic rule ensuring that all transactions are properly recorded and the books always balance. Understanding assets, liabilities, and equity – and how they interact – is essential for accurate bookkeeping, preparation of financial statements, and answering questions in the FA2 exam. This article provides clear definitions, shows how these elements are classified, and explains how typical transactions affect the equation.

Key Term: accounting equation
The fundamental formula: assets equal liabilities plus equity (Assets = Liabilities + Equity).

The Accounting Equation Explained

The accounting equation expresses the relationship between:

• what the business owns (assets),
• owes to others (liabilities), and
• the owner’s residual interest (equity).

It can be stated as:

Assets = Liabilities + Equity

This equation must remain true after every transaction entered into by the business.

Key Term: asset
A resource controlled by the entity as a result of past events, from which future economic benefits are expected.

Key Term: liability
A present obligation of the entity arising from past events, settlement of which is expected to result in an outflow of resources.

Key Term: equity
The residual interest in the entity’s assets after deducting all liabilities; usually called capital in unincorporated businesses.

Elements of the Accounting Equation

Assets

Assets are resources such as cash, receivables, inventory, equipment, vehicles, and property. Assets may be:

• Current assets: Expected to be converted into cash or used up within 12 months (e.g., inventory, trade receivables, cash).
• Non-current assets: Held for more than 12 months and used in producing revenue over multiple accounting periods (e.g., plant, vehicles, property).

Key Term: current asset
An asset expected to be used, sold, or realised in cash within 12 months of the reporting date.

Key Term: non-current asset
An asset held for use within the business and not expected to be consumed or realised within 12 months.

Liabilities

Liabilities represent claims by external parties, including trade payables, loans, overdrafts, and accruals. They are divided into:

• Current liabilities: Due to be settled within 12 months (e.g., trade payables, bank overdrafts, tax payable).
• Non-current liabilities: Due after more than 12 months (e.g., bank loans repayable in over a year).

Key Term: current liability
A liability due for settlement within the next 12 months.

Key Term: non-current liability
A liability not expected to be settled within the next 12 months.

Equity

Equity (or capital) is the residual interest in assets after liabilities are paid. For sole traders and partnerships, equity typically consists of:

• Initial and additional capital invested
• Plus: profits retained in the business
• Less: drawings (withdrawals) by the owner(s)

Key Term: drawings
Withdrawals of cash or assets from the business by the owner(s) for personal use; these reduce equity.

The Effect of Transactions on the Equation

Every transaction affects at least two elements of the accounting equation, keeping both sides in balance. Examples:

• Purchasing inventory for cash – reduces cash (asset) and increases inventory (asset): total assets unchanged.
• Buying equipment with a bank loan – increases equipment (asset) and increases loan (liability): assets and liabilities both increase.
• Owner introduces capital – increases cash (asset) and increases equity.
• Owner withdraws cash – decreases cash (asset) and decreases equity.

Worked Example 1.1

An owner starts a business with £10,000 deposited into the business bank account.

Answer:

• Assets (cash at bank) increase by £10,000
• Equity (capital) increases by £10,000
• Liabilities remain unchanged

Accounting equation: Assets £10,000 = Liabilities £0 + Equity £10,000

Changes Due to Profit or Loss

Profits increase equity, while losses reduce it. Profit earned in a period is added to equity; any drawings are deducted.

Expanded equation:

Assets = Liabilities + (Capital + Profit – Drawings)

Or rearranged:

Assets – Liabilities = Capital + Profit – Drawings

Worked Example 1.2

A business starts with £7,000 cash introduced by the owner (Day 1). On Day 2, it buys inventory costing £2,500 on credit. What is the effect on the accounting equation?

Answer:
Day 1:

• Assets: £7,000 (bank)
• Equity: £7,000

Day 2:

• Assets: £7,000 (bank) + £2,500 (inventory) = £9,500
• Liabilities: £2,500 (payable)
• Equity: £7,000

Therefore, Assets (£9,500) = Liabilities (£2,500) + Equity (£7,000)

Effect of Drawings

Drawings are amounts taken out of the business by owners. They reduce the capital/equity balance; drawings do not count as expenses in the profit or loss statement.

Worked Example 1.3

A sole trader has the following balances: assets £15,000, liabilities £3,000, drawings during the year £1,000, and generated a profit of £4,000. What is the closing equity?

Answer:
$\text{Closing equity} = \text{Opening equity} + \text{Profit} – \text{Drawings}$

But using the accounting equation: $\text{Equity} = \text{Assets} – \text{Liabilities} = £15,000 – £3,000 = £12,000$

Alternatively, if opening equity was, say, £9,000, then: $£9,000 + £4,000 – £1,000 = £12,000$

Account Types and Financial Statements

Accounts in the general ledger are grouped according to their type:

• Asset accounts (e.g. cash, inventory, equipment)
• Liability accounts (e.g. bank loans, payables)
• Equity/capital accounts (including profit and drawings)
• Income and expense accounts (affect profit and thus equity over time)

Statement of Financial Position and the Accounting Equation

The statement of financial position (balance sheet) presents assets, liabilities, and equity at a point in time, reflecting the accounting equation in financial statement format:

Exam Warning

Confusing drawings with business expenses is a common error. Drawings always reduce equity—not included as expenses—and never affect profit for the period.

Summary

The accounting equation (Assets = Liabilities + Equity) is the core rule which ensures that all accounting records remain balanced. Classifying items accurately as assets, liabilities, or equity and understanding how transactions affect the equation is essential for preparing reliable accounts and succeeding in the ACCA FA2 exam.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and apply the accounting equation
• Identify and classify assets, liabilities, and equity, including current and non-current types
• Explain the effect of transactions on the equation and on equity
• Understand how profit and drawings impact the owner’s capital
• Relate financial statement accounts to the accounting equation

Key Terms and Concepts

• accounting equation
• asset
• liability
• equity
• current asset
• non-current asset
• current liability
• non-current liability
• drawings