Accounting equation and account types - Income and expenses ...

Learning Outcomes

After studying this article, you will be able to explain the accounting equation, identify and classify the main types of accounts, and distinguish between income and expenses. You will understand how these elements connect to double-entry bookkeeping and how correct classification affects the statement of profit or loss and the statement of financial position for the ACCA Maintaining Financial Records (FA2) exam.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand the role of the accounting equation and how various accounts—especially income and expenses—are classified and reported in the financial statements. This article addresses the following key syllabus areas:

• The meaning and application of the accounting equation
• The elements of financial statements: assets, liabilities, capital, income, expenses
• Double-entry principles and how ledger accounts are updated
• Classification of expenditure between assets and expenses (income vs. expense accounts)
• The effect of correct and incorrect classification on profit measurement and financial statements

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. Which of the following best describes the accounting equation?
   1. Assets = Income + Expenses
   2. Assets = Capital + Liabilities
   3. Liabilities = Assets + Expenses
   4. Capital = Assets + Liabilities

2. Select the correct classification for the following items: i) Wages paid ii) Inventory at year end iii) Sales revenue iv) Trade payables

3. True or false? A decrease in an expense account is entered on the credit side of that account.

4. What is the main impact of wrongly classifying an expense as an asset on the financial statements?

Introduction

The accounting equation is central to financial accounting. It shows the relationship between an entity’s assets, liabilities, and capital. Every transaction must maintain this balance, and all accounts must be accurately classified to ensure financial statements are correct.

Accurate classification between income and expenses is essential for measuring profit. Misclassification leads to incorrect profit reporting and misleading financial information. For ACCA FA2, you must understand not just the bookkeeping entries but why account types matter and how they are used to prepare financial statements.

Key Term: accounting equation
The formula representing the relationship between an entity’s assets, liabilities, and capital:
Assets = Capital + Liabilities

The Accounting Equation

The accounting equation is always in balance. It forms the basis of double-entry bookkeeping.

Double-Entry Principle

Every transaction has two effects—one debit and one credit. This duality ensures the accounting equation remains balanced after each entry.

Breaking Down the Equation

Assets are resources controlled by the entity. Liabilities are present obligations to transfer resources. Capital (or equity) is the residual interest after deducting liabilities.

Key Term: asset
A present economic resource controlled by the entity as a result of past events.

Key Term: liability
A present obligation to transfer an economic resource as a result of past events.

Key Term: capital
The residual interest of the owner in the assets of an entity after deducting all liabilities.

Income and Expenses Effect

When a business earns income, assets increase or liabilities decrease, resulting in more capital/profit. Expenses, in contrast, decrease assets or increase liabilities, reducing capital/profit.

Key Term: income
Increases in assets or decreases in liabilities that result in an increase of capital (such as sales revenue or interest income).

Key Term: expense
Decreases in assets or increases in liabilities that lead to a reduction in capital (such as rent paid or utilities expense).

The Expanded Equation

Including income and expenses gives this form:

Assets = Capital at start + Additional Capital + Income – Expenses – Drawings + Liabilities

Profit (or loss) is the total of income less expenses for the period.

Classification of Accounts: Account Types

All account entries in the general ledger relate to one of five elements:

• Assets
• Liabilities
• Capital
• Income
• Expenses

Asset Accounts

Assets include items like cash, receivables, inventory, and property. An increase in an asset account is recorded as a debit; a decrease is a credit.

Liability Accounts

Liabilities include payables, loans, and overdrafts. An increase is a credit; a decrease is a debit.

Capital Accounts

For a sole trader or partnership, capital represents the owner’s stake. Increases (capital introduced, profit) are credits; decreases (drawings, losses) are debits.

Income Accounts

Income is money earned from normal operations—sales, interest received, discounts received. Increases are credited; decreases are debited.

Expense Accounts

Expenses are costs incurred in earning income, e.g. wages, utilities, rent, depreciation. Increases are debited; decreases are credited.

Key Term: account classification
The process of grouping transactions under the correct account type: asset, liability, capital, income, or expense.

Income and Expenses: Classification and Impact

Income and expenses are presented only in the statement of profit or loss. Assets, liabilities, and capital appear in the statement of financial position.

Expenses vs. Asset Expenditure

An expense is consumed within the period, such as wages or rent. An asset expenditure is a purchase expected to bring benefit over more than one period (e.g. equipment). Correct classification is essential.

Wrongly treating an asset purchase as an expense will reduce reported profit and understate assets. Recording an expense as an asset overstates profit and assets.

Worked Example 1.1

A business buys a motor vehicle for $10,000 (expected to be used for several years), but records it as a "Motor Vehicle Expense."

Question: What is the impact on the current year's financial statements?

Answer:

• The expense account will be overstated by $10,000, reducing profit unnecessarily.
• Non-current assets will be understated, as the vehicle does not appear as an asset.
• Capital will be understated in the statement of financial position.

Worked Example 1.2

Celia receives $2,000 as commission (income) from a supplier and pays$700 for electricity. How do these affect the accounting equation?

Answer:
Commission (income) increases assets (cash) and profit/capital.
Electricity (expense) decreases assets (cash) and reduces profit/capital.
Both entries keep the equation balanced.

Worked Example 1.3

Chris Ltd buys inventory on credit for $3,500. Classify and record the transaction.

Answer:
Inventory (asset) increases — debit Inventory $3,500 Payables (liability) increases — credit Payables$3,500

Exam Warning

Misclassifying expenses as assets, or vice versa, will distort both the profit reported and net assets shown. ACCA exams frequently test your ability to spot such errors in practical scenarios.

Summary

The accounting equation (Assets = Capital + Liabilities) must balance after every transaction. Clear classification of each account as asset, liability, capital, income, or expense is essential for correct recording. Income and expenses determine profit and appear only in the statement of profit or loss, while assets, liabilities, and capital appear in the statement of financial position. Incorrect classification affects reported profit and asset values.

Key Point Checklist

This article has covered the following key knowledge points:

• The accounting equation and its components
• Main account types: assets, liabilities, capital, income, expenses
• Double-entry bookkeeping and the role of debits/credits for each account type
• Correctly classifying expenses and asset expenditure
• The impact of account classification errors on financial statements

Key Terms and Concepts

• accounting equation
• asset
• liability
• capital
• income
• expense
• account classification