The Accounting Equation (Edexcel IGCSE Accounting)

Revision Note

The Accounting Equation

What is the formula for the accounting equation?

  • The formula for the accounting equation is: Assets = Liabilities + Equity

  • The equation states that the assets of a business are always equal to the liabilities and equity of the business 

  • You can rearrange the equation so that you can find one of the three values if the other two are known

    • Liabilities = Assets - Equity

    • Equity = Assets - Liabilities

The accounting equation: Assets equal liabilities plus equity
The accounting equation

What are assets?

  • Assets are things owned by the business

    • Premises, inventory, motor vehicles, money in the bank, etc

  • Assets also include amounts that are owed to the business by other people or businesses

    • Money owed to the business by credit customers

      • These are called trade receivables

  • Current assets are short-term assets that the business intends to liquidate within a year

    • Trade receivables, inventory, money in the bank, etc

  • Non-current assets are long-term assets that the business intends to own for more than a year and they are not easily liquated

    • Premises, motor vehicles, etc

What are liabilities? 

  • Liabilities are the amounts that the business owes to other people or businesses

    • Bank loans, bank overdraft, etc

    • Money owed to credit suppliers by the business

      • These are called trade payables

  • Current liabilities are short-term liabilities which the business intends to pay within a year

    • Trade payables, bank overdraft, etc

  • Non-current liabilities are long-term liabilities which the business intends to take longer than a year to repay

    • Bank loans, etc

What is equity?

  • Equity is any resource provided by the owner to start up the business or keep it going 

    • This is sometimes referred to as owner’s equity or capital

  • Equity is often in the form of money

    • However, it may also consist of other assets

      • Such as buildings, furniture, equipment, motor vehicles, goods, etc

  • The owner invests capital into their business

    • Technically the business owes these assets to the owner

  • If a business makes a profit then its equity increases

  • If a business makes a loss then its equity decreases

What are drawings?

  • Drawings refer to when an owner takes assets from the business for personal use

    • This could be money, goods, motor vehicles, etc

  • If the owner takes drawings from the business then the equity decreases

Examiner Tips and Tricks

You may be given examples of assets and liabilities and asked to calculate the missing figure for equity.

Worked Example

The assets and liabilities are listed below for a business.

$

Premises

8 500

Equipment

7 000

Inventory

1 000

Trade receivables

5 000

Trade payables

4 500

Bank overdraft

1 200

Calculate the equity of the business.

Answer

Firstly, calculate the total assets:

$

Premises

8 500

Equipment

7 000

Inventory

1 000

Trade receivables

5 000

Total assets

21 500

Secondly, calculate the total liabilities:

$

Trade payables

4 500

Bank overdraft

1 200

Total liabilities

5 700

Finally, apply the formula Equity = Assets - Liabilities

$21 500 - $5 700 = $15 800

Why is the accounting equation important?

  • The accounting equation may be shown in the form of a statement of financial position 

  • The statement of financial position will be affected every time the business makes changes to the assets, liabilities and equity

  • Every single transaction will result in at least two changes which balance out

    • Both sides of the equation could increase by the same amount

    • Both sides of the equation could decrease by the same amount

    • Both sides of the equation could stay the same

Case Study

Hannah is the owner of a business. Some of her transactions are listed below. After each transaction, the accounting equation still balances.

Transaction

Effects on assets

Effects on liabilities or equity

A credit customer, Peter, pays the amount owed to Hannah by cheque for $1 120

Assets increase by $1 120

The money in the bank increases

Assets decrease by $1 120

The amount owed by Peter decreases

Overall no change to assets

No change in liabilities or equity

Hannah pays the amount owed to a credit supplier, Rizwan, by cheque for $4 200

Assets decrease by $4 200

The money in the bank decreases

Liabilities decrease by $4 200

The amount owed to Rizwan decreases

Hannah buys additional fixtures and fittings for $5 500 on credit from FixFit Ltd

Assets increase by $5 500

The value of Hannah's assets increases

Liabilities increase by $5 500

The amount owed to FixFit Ltd increases

Hannah takes goods worth $500 from the business for personal use

Assets decrease by $500

The amount of inventory decreases

Equity decreases by $500

Hannah takes drawings from the business

Hannah transfers $1 000 from her personal bank account into the business bank account

Assets increase by $1 000

The money in the bank increases

Equity increases by $1 000

Hannah invests $1 000 into the business

Hannah makes $20 profit by selling goods which cost $30 for $50 cash

Assets increase by $50

The amount of cash increases

Assets decrease by $30

The amount of inventory decreases

Overall assets increase by $20

Equity increases by $20

A profit has been made

Worked Example

A business pays one of its trade payables by cheque. Identify the effects on the business' assets and liabilities.

 

Effect on assets 

Effect on liabilities 

Reduce bank 

Reduce trade payables 

Increase bank 

Increase trade payables 

Reduce trade payables 

Reduce bank 

D

Increase trade payables 

Increase bank 

Answer

Money in the bank is an asset and trade payables is a liability. A payment made by cheque would reduce the money in the bank, therefore reducing the asset.  Trade payable is a liability.  The business debt would be reduced when payment is made.

The answer is A.

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Donna Simpson

Author: Donna Simpson

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Donna is a classroom practitioner with over 25 years experience in teaching accounting and business studies at GCSE A-Levels and undergraduate levels, both in the UK and abroad. She currently works for a Multi-Academy Trust (MAT) as a teacher, instructional coach and mentor to other teachers. Donna is also an AQA A Level Accounting examiner as well as the content creator of resources used by all accounting teachers across the Trust. She enjoys designing and creating resources that provides students with deeper understanding of the subject content. Donna has a Bachelor of Science Degree in Business Administration with major in Accounting and Finance (BSc Hons) and ACCA certified to Level 2.

Dan Finlay

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Dan graduated from the University of Oxford with a First class degree in mathematics. As well as teaching maths for over 8 years, Dan has marked a range of exams for Edexcel, tutored students and taught A Level Accounting. Dan has a keen interest in statistics and probability and their real-life applications.