The Accounting Equation

The accounting equation expresses the relationship between everything a business owns (assets) and the two sources of funding for those assets — the owner's own investment (capital) and money borrowed from others (liabilities).

$\text{Assets} = \text{Capital} + \text{Liabilities}$

It can be rearranged to find any missing element:

$\text{Capital} = \text{Assets} - \text{Liabilities}$ $\text{Liabilities} = \text{Assets} - \text{Capital}$

Why is the equation always balanced? Because of the dual aspect concept: every transaction has two effects of equal value. When a business acquires an asset, it must either spend cash (reduce another asset), borrow money (create a liability), or the owner must invest more capital. There is no way to gain something without a corresponding change somewhere else.

Example 1: Owner invests $20,000 cash into the business.

• Assets ↑ Cash +$20,000
• Capital ↑ +$20,000
• Equation: Assets ($20,000) = Capital ($20,000) + Liabilities ($0) ✓

Example 2: Business buys equipment on credit for $5,000.

• Assets ↑ Equipment +$5,000
• Liabilities ↑ Trade payables +$5,000
• Equation: Assets ($25,000) = Capital ($20,000) + Liabilities ($5,000) ✓

Example 3: Business pays $3,000 cash to a supplier.

• Assets ↓ Cash −$3,000
• Liabilities ↓ Trade payables −$3,000
• Equation: Assets ($22,000) = Capital ($20,000) + Liabilities ($2,000) ✓

Assets are resources owned or controlled by the business from which future economic benefits are expected to flow. They are the things the business uses to generate income.

Assets are divided into two categories based on how long they are expected to remain in the business:

Non-current assets (previously called fixed assets): held for more than one year; used repeatedly to generate income rather than being sold in the normal course of business.

• Land and buildings
• Machinery and plant
• Motor vehicles
• Office equipment and furniture
• Fixtures and fittings

Current assets: expected to be converted into cash within one year (the operating cycle). They circulate through the business.

• Inventory (stock of goods for resale or raw materials)
• Trade receivables (debtors — customers who owe money for credit sales)
• Bank balance (money held in the bank account)
• Cash (notes and coins in the till)
• Prepayments (expenses paid in advance, e.g., rent paid before the period it covers)

Order of liquidity: current assets are usually listed in order from least liquid to most liquid: inventory → trade receivables → bank → cash. (Liquidity = how quickly an item can be turned into cash.)

Capital (also called owner's equity or net worth) represents the owner's claim on the business's assets. It is the residual interest after all liabilities have been deducted from assets.

$\text{Capital} = \text{Assets} - \text{Liabilities}$

Capital changes over time according to the following formula:

$\text{Closing Capital} = \text{Opening Capital} + \text{Net Profit} + \text{Additional Capital Introduced} - \text{Drawings}$

Components:

• Opening capital: the capital balance at the start of the accounting period.
• Net profit: increases capital because the business has earned more than it has spent; the profit belongs to the owner.
• Net loss: reduces capital (treated as a negative profit in the formula).
• Additional capital introduced: new cash or assets the owner puts into the business during the period.
• Drawings: cash or goods the owner takes out of the business for personal use; reduces capital because the owner is withdrawing their investment.

Example:

• Opening capital: $15,000
• Net profit for the year: $8,000
• Additional capital introduced: $2,000
• Drawings: $5,000
• Closing capital = $15,000 + $8,000 + $2,000 − $5,000 = $20,000

Capital appears on the credit side of the accounting equation because it represents a claim (liability of the business to the owner). This is the business entity concept — the business is treated as separate from its owner.

Liabilities are the obligations of the business — amounts it owes to external parties that must be settled in the future by transferring assets (usually cash).

Like assets, liabilities are divided by time horizon:

Non-current liabilities: obligations not due within the next twelve months; long-term funding.

• Long-term bank loans (e.g., a 5-year business loan)
• Mortgages (loan secured on property)
• Finance leases (long-term)

Current liabilities: obligations due to be settled within one year.

• Trade payables (creditors — money owed to suppliers for goods/services bought on credit)
• Bank overdraft (the bank is owed money; repayable on demand)
• Accruals (expenses incurred but not yet paid, e.g., wages owing at year end)
• Short-term loans (due within 12 months)
• Income received in advance (deferred income)

Working capital: the difference between current assets and current liabilities. It measures the business's ability to meet short-term obligations:

$\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}$

A positive working capital means the business can pay its current debts from its current assets — a healthy liquidity position.

Understanding how different transaction types affect the accounting equation is essential for Cambridge IGCSE exams. There are several patterns to recognise:

Type 1 — Asset increases, another asset decreases (no net change in total assets, no change to capital or liabilities):

• Buy goods for cash: Inventory ↑, Cash ↓

Type 2 — Asset increases, liability increases (both sides of the equation increase equally):

• Buy equipment on credit: Equipment ↑, Trade Payables ↑

Type 3 — Asset increases, capital increases (both sides increase):

• Owner invests cash: Cash ↑, Capital ↑

Type 4 — Asset decreases, liability decreases (both sides decrease equally):

• Pay a supplier: Cash ↓, Trade Payables ↓

Type 5 — Asset decreases, capital decreases:

• Owner takes drawings: Cash ↓, Capital (Drawings) ↓

Type 6 — Capital changes from profit/loss:

• Record profit: Capital ↑ (retained profits increase equity; the corresponding asset increase is spread across multiple asset and liability accounts)

Summary table:

Transaction	Assets	Capital	Liabilities
Owner invests cash	↑	↑	—
Buy goods for cash	↑↓ swap	—	—
Buy equipment on credit	↑	—	↑
Pay supplier	↓	—	↓
Owner takes drawings	↓	↓	—
Make a sale on credit	↑ TR	↑ profit	—