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I don't get this, I feel this should be easy but I just can't get my head round the accounting equation. I can't see how the capital put into a company can equal the assets less the liabilities.
Surely the capital put into the startup of a company remains the same now matter how much profit or loss the company makes.
I get that the company's worth is assets less liabilities.
Can someone give an example, using a storyboard if neccessary to help me understand this?? Use any metaphors or analogies you like, I feel like I need shooting coz I can't understand this....
Thanks
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You are getting there, but you then need to remember at the end of the year the profit is transfered to the capital account less the drawings for that year. So although the capital introduced doesn't always change the capital account will. I suppose when you think about it anything you own, less anything you owe must either have been bought from money you put in or money you made and together these make up the capital, or net worth.
You can also put extra capital in after the initial injection.
Hope this helps a bit.
Kris
Edited at 23 Nov 2011 10:07 PM GMT
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Hi
This is what helped me I am qouting from my Leaving Cert Book in Ireland when I was 17 over 25 years ago. This book written by extremely talented Frank Woods and Published in 1993 sixth Edition .
I have added a few things to modernise it but in the words of Frank Wood's
Business accounting 1 Edition
" The Whole of Financial Accounting is based upon a very simple idea. This is called the accounting equation which sounds complicated , but in fact is easy to understand.
It can be explained by saying that, if a firm is to set up , and start trading , then it needs resources . Let us assume that in the first place it is the owner of the business who has supplied all of the resources . This can be shown as:
Resources in the business = Resources supplied by the owner.
In accounting , terms are used to decribe things . The amount of the resources supplied by the owner is called CAPITAL . The actual resources that are then in the business are called ASSETS. This means that the accounting equation above ,
when the owner has supplied all of the resources , can be shown as
ASSETS = CAPITAL
Usually , however , people other than the owner have supplied some of the assets. LIABILITIES is the name given to the amounts owing to these people eg banks loans , Creditors for these assets. The EQUATION has now changed to :
ASSETS = CAPITAL + LIABILITIES
It can be seen that the two sides of the equation will have the same totals. This is because we are dealing with the same thing form two different points of view . It is
Resources: what they are = Resources who supplied them
(Assets ) (Capital + Liabilities )
It is a fact that the totals of each side will always equal one another, and that this will always be true no matter how many transactions there may be. The actual assets, capital and Liabities may change, but the total of the assets will always equal the total of Capital plus Liabilties.
Assets consist of property of all kinds , such as buildings , machinery , stocks of goods and motor vehicles. Also benefits such as debts owed by customers and the amount of money in the bank account are included.
Liabilities consist of money for goods supplied to the firm and for expenses . Also loans made to the firm are included.
Capital was often in the past was known as the owners equity or net worth.
Think of it this way.
The Balance Sheet and the Effects of Business Transactions
The accounting equation is expressed in a financial position statement called the balance sheet. It is not the accounting record to me made but ist is a convenient place to start to consider accounting.
1) The Introduction of Capital
2) The purchase of an Asset by cheques, DPC or Bacs
3) The Purchase of an Asset and the incurring of a Liability
4) Sale of an Asset on Credit
5) Sale of an asset for immediate Payment
6) The payment of a Liabiltilty
Think how all these transactions all involve debits and Credits.
Finally the Equality of the Accounting Equation
It can be ssen that every transaction has affected two items. Sometimes it has changed two assets by reducing one and increasing another. Other items it has reacted differently . Here is a summary of the effect of some transactions upon assets, liabilities and capital below.
Example of transaction effect
1 Buy goods on credit Increase Asset Increase Liability
(stock of goods ) (Creditors)
2 Buy goods by cheque Increase Asset Decrease asset
( stock of goods ) ( Bank)
3 Pay Creditor by Bacs Decrease Asset (Bank ) Decrease Liability (Creditors)
4 Owner take money out of the business
bank for his own use Decrease Asset (Bank) Decrease Capital
My Statement.
This is just my opinion if you get the opportunity for extra reading and can get a hold of a old copy of Frank Woods Business Accounting 1 . It shows you the T accounts very clearly really explains your debits and credits . I had this book the original when I was 17 no other book was as good as explaining the equation.
I hope this helps
Edited at 23 Nov 2011 10:35 PM GMT
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sarahsaid:
My Statement.
This is just my opinion if you get the opportunity for extra reading and can get a hold of a old copy of Frank Woods Business Accounting 1 . It shows you the T accounts very clearly really explains your debits and credits . I had this book the original when I was 17 no other book was as good as explaining the equation.
I have two versions of the same book - the 3rd edition and the 11th edition. It's amazing to see how the size of the book has grown over the years as well as the number of pages has ballooned.
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A fantastic answer by Sarah and a great book recommendation. I used Frank Woods book 20 years ago when I first started studying bookkeeping and it was brilliant. Evurr - hope this has helped you but if not, get a copy of the book. It doesn't have to be a recent one if cost is a problem but even an early one will help you hugely.
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Hi Thanks for the suggestion of the book but I have it and have read that section (I'm spending a week on the book before I submit my first assignment). My understanding is better after reading the section in the book, but not complete.
I am wondering, do I just accept it blindly or doI continue to truly understand it? Is it the sort of thing that I would be asked about in an exam? I can repeat the formula but don't totally understand it enough to explain it.
Have to say I'm not ALL that impressed with the woods book so far... it spent the first few pages scaring me of the exam that I am no where near ready to take. I feel like young karate kid standing in front of Mr Miaggi being told to paint a fence... it appears important but I have no idea why at the moment.
Whatever happened to starting at the basics? But hey, I know soooo many people use the book and have never complained so I am aware that it is just little me being whiney.....
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In my opinion it is VITAL that you fully understand the Accounting Equation to understand double entry bookkeeping. Everything that you will go on to study stems from that basic point so do not just blindly accept it but research and read as much as you need to to get a complete understanding. You have done the right thing by coming on here - perhaps other members may have tricks or examples that helped them to remember it...?
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HI
Lets us know which area you are struggling with and we can try to help
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Hi Evurr
Have you tried Youtube - there are some excellent videos on there that i used to recap my knowledge - there is an American lady on there called Susan Cusson - look at her videos they actually look at it on a step by step basis.
Regards
Acorn
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One link that a friend of mine has used to study is http://www.dwmbeancounter.com/tutorial/lesson02.html
Try looking at the other lessons as well... sometimes just a different wording of the explanation is all that you need...
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Claresaid:
“One link that a friend of mine has used to study is http://www.dwmbeancounter.com/tutorial/lesson02.html
Try looking at the other lessons as well... sometimes just a different wording of the explanation is all that you need... ”
These are my thoughts... I know when you're studying a new topic terminology can be a big stumbling block to learning. People use words that they think others understand, when some (like me) just don't.
I will look at the sites suggested, thanks. I think I need a story to help me understand i.e. Frank put £100 pounds into his new business, he then sold £50 of stock making £20 profit.... etc etc....
Will check out youtube.. impressed it's not just for watching funy cat clips :o)
I will add, I do get the concept of double entry and the like.. that all makes sense... it is just this pesky equasion that I am getting lost on.
Edited at 24 Nov 2011 03:17 PM GMT
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So for example...
Clare has £1000 which she puts into her new business. So Clare no longer has the £1000 but is owed it by the business meaning that the business (always remembering that Clare and her business are separate beings) has £1,000 in cash but also has a debt of £1,000 to Clare (this is capital, not liability as Clare is the business owner)
Hence
Assets (£1000) = Capital (£1000) + Liabilities (£0)
so £1000 = £1000
If the business then purchases a car on credit for £2000 then they have an additional asset worth £2000 but also owe £2000 to the bank meaning:
Assets (£1000 + £2000) = Capital (£1000) + Liabilities (£2000)
So £3000 = £3000
Does that make sense?
The reason I say that it's fundamental and vital that you understand it is that when you reach the Balance Sheet part of your studies you will find that the whole balance sheet is based on this equation!
Here's a couple to try using my method above:
If Clare's business takes out a bank loan for £3000 what effect does that have?
If Clare's business sells the car for £2500 what effect does that have?
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Hi
I am going to give a story a shot, so bear with me. I hope it helps.
I am starting up a business called pretend Ltd on 1st April 2011
1) The first thing I need to is to get a loan for my business as I have no money. The bank have given me a loan of £75,000 ( Its is nice to dream )
This would be my entry
Db Cr
01/04/2011 Bank Account 75,000
Loan Account 75,000
My bank is a current Asset and Loan is Curent Liability so at the moment they both equal each other.
2) The next thing I need to do is to buy some computer equipment £1,750 but I paying by cheque straight away so their not a creditor.
Db Cr
02/04/2011 Bank Accouint £1,750
Computer Equipment £1, 750
At this point you will see that my Current Assets Bank Account has a Db Balance of £73,250 Fixed Assets has Dr balance of £1,750 and my Loan Account as a balance of £75,000
So after theses 2 transactions we now have
Fixed Assets plus Current Assets = Long Term Liabilities
Computer Euipment £1,750 = Loan Account £75,000
Bank Account £73250
3 ) I now want to set up a major supplier for what I need to purchase £25,000 to sell my product. So in real life they probably would be a creditor. They have given 30 days to pay.
Db Cr
03/04/11 Cost of Sales (Profit an Loss) 25,000
Creditors Contol Account 25,000
Yeepee ring a big bell . I have my first Sale of £136,000 . But he is not paying for 30 days so he will be a debtor
and I have also just heard I have made another sale but they are paying a chq straight of £4,000
Dr Cr
04/04/11 Sales (Profit and Loss) 136,000
Debtors Control 136,000
04/04/11 Sales (Profit and Loss ) 4,000
Bank Account (Balance Sheet) 4.000
Oh dear I have to pay by Direct Debit the companys Rent by D/D of £900 and the first payment of Loan of £3,500 including a £100 pound of Interest
Dr Cr
30/04/11 Rent (Profit and Loss) 900
Bank A/c ( Current Asset ) 900
Loan Int (Profit and Loss) 100
Loan (Long term Liabilties 3400
Bank 3, 500
As you will see I am developing a small P&L for demostration. It is this figure that is the Profit and Loss figure in the balance sheet .
I now have a small P& L that looks like this
Pretend Ltd Profit And Loss for period 30th April 2011
Sales 140,000
Less : Cost of Sales 25,000
Rent 900
Loan Interest 100
Total Expenses 26.000
Gross Profit 114,000 (This is my balancing figure)
This is how the balance sheet looks now We want to understand the accounting equation
Assets = Liabilities
Fiixed Asset + Current Assets = Current Liabilities + Liabities > 1 Year + Capital
Computer Equip £1,750 Bank Account £72,000 Creditors £25,000 Loan Account £71,600 Gross
Profit
Debtors Control £136,000 £114,000
Total Assets £210,600 = Total Liabilities £210,600
Some Notes:
you will notice that I did not reduce by loan account by the 100 interest this is a common mistake. It is Profit and loss Item as it is an expense
Profit and Loss
Remember every where ever there is a debit there is a credit in the Profit and Loss or Balance sheet. If the company make a profit then this is used for Capital to Finance the Business.
If the company makes a loss then we reduce the the capital that is available to the company.
I think it may be this balancing figure that is confusing you. But to find out how much money we made we first need to work the profit or loss the balanceing figure is was sits in your Capital Profit and Loss reserve.
Edited at 24 Nov 2011 04:37 PM GMT
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Thanks again for taking the time to help me with this.. you all rock!! I'm getting there :o)
It makes sense for a minute and then it's gone again... it's a very odd feeling and makes me think I am slightly insane LMAO!!!
Out of interest. I see that it is connected to the Balance Sheet... I've not got that far. Is it possible that the course will go into more depth when I get there and I am trying to run before I walk?
There may be exercises both in the course and in Woods that help me understand this.
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Hi
If you have not study the balance sheet yet , this might be why you did not understand. I would not worry to much. The fact that you have gone to the real bother of getting your head around everything will make you a very goodbookkeeper for the future.
I had to do the same as I did not get it. I passsed early exams and then I got into bother because i accepted it with out understanding it. I had two good friends that spent hours and hours getting me through my exams over 20 years ago.
Edited at 25 Nov 2011 01:22 PM GMT
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had a brainstorm this morning while in the shower (where I do my best thinking)
The thing I am struggling with is that I see capital as what you started the business up with and this in my head (possibly wrongly) is a fixed figure..... but if you throw profits into the mix it makes more sense.
My head kept saying, what if your business isn't doing well and you are making a loss, that would make capital smaller than the amout you put in... but if i look at it as
capital indroduced + profites = assets - liabilities
then if you are making a loss the profits bit will be a minus figure, making capital introduced smaller.
Can you tell me if I am close now?
Hi Sarah
Thank you for your reply. It does feel like this has been thrown in at the start and then left alone, there is no depth to the information and it looks like it needs to be blind belief.... and I just don't do blind belief in any aspect of my life.
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Hey there
I know I've taken up a lot of your time but can someone check my last post to see if it's right. This would be the end of this thread then.....
Sorry to be a pain
Thanks
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Evurrsaid:
“Hey there
I know I've taken up a lot of your time but can someone check my last post to see if it's right. This would be the end of this thread then.....
Sorry to be a pain
Thanks”
oh well, never mind. I guess I had better find somewhere else to ask.
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Hey,
I only read the last couple of comments, but maybe the lack of answer is because you have cracked it, because what you have written looks right to me!
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Cherylsaid:
“
Hey,
I only read the last couple of comments, but maybe the lack of answer is because you have cracked it, because what you have written looks right to me!
”
Thank you for taking the time Cheryl, that was all I wanted, for someone to confirm whether or not I was on the right track. The lack of a response does not give that confirmation.
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I know exactly what you mean about it making sense for a second and then being gone again, Im finding exactly the same thing! lol.
The main thing I'm struggling to get my head around at the moment is the vertical method with the balance sheet as it just doesn't seem to have been explained and covered enough in the course material. So much time was spent learning the horizontal method that the vertical method now just confuses me. I think it would have been a lot easier to have just been taught the vertical method to begin with to save any confusion and at least it would have been explained in greater detail 
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Sorry to hear you too are struggling. I have just written a very long e-mail to my tutor explaining why I am very unhappy with my course material. There is so much missing and when I ask questions from my tutor she contradicts herself, and the course material.
I really hope you get to grips with it. We haven't covered balance sheets at all, Trial Balance yes, but not Balance Sheets. Are you on level 1? I have completed all that I had in my level 1 and I have to say I'm not all that confident that I have been taught enough.
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Yes I've just completed my first assignment on level 1. I've noticed too that certain things seem to be quite contradictory which just adds to the confusion. How strange that you haven't covered balance sheets at all  I think you've done the right thing contacting your tutor. I hope you manage to get it sorted out.
Evurrsaid:
“Sorry to hear you too are struggling. I have just written a very long e-mail to my tutor explaining why I am very unhappy with my course material. There is so much missing and when I ask questions from my tutor she contradicts herself, and the course material.
I really hope you get to grips with it. We haven't covered balance sheets at all, Trial Balance yes, but not Balance Sheets. Are you on level 1? I have completed all that I had in my level 1 and I have to say I'm not all that confident that I have been taught enough.”
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Embersaid:
“Yes I've just completed my first assignment on level 1. I've noticed too that certain things seem to be quite contradictory which just adds to the confusion. How strange that you haven't covered balance sheets at all I think you've done the right thing contacting your tutor. I hope you manage to get it sorted out.
”
If I am honest the problems I have had with this course have been multiple and I have been talking to the provider, but it seems they are just going to give me a new tutor and hope that solves them.
It turns out the reason I couln't grasp the accounting equation is because I wasn't taught how it was applied. I bought the Kaplan revision book and the first question asks me to describe a list of transactions using the accounting equation. I had no idea as I had never seen it being used. I had to look at the answer in the back to see what I was even aiming at.
This to me is fairly fundamental, if the Kaplan book is asking me to know this I am guessing there is a possiblity that an exam will ask me too.
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Evurrsaid:
“Embersaid:
“Yes I've just completed my first assignment on level 1. I've noticed too that certain things seem to be quite contradictory which just adds to the confusion. How strange that you haven't covered balance sheets at all I think you've done the right thing contacting your tutor. I hope you manage to get it sorted out.
”
If I am honest the problems I have had with this course have been multiple and I have been talking to the provider, but it seems they are just going to give me a new tutor and hope that solves them.
It turns out the reason I couln't grasp the accounting equation is because I wasn't taught how it was applied. I bought the Kaplan revision book and the first question asks me to describe a list of transactions using the accounting equation. I had no idea as I had never seen it being used. I had to look at the answer in the back to see what I was even aiming at.
This to me is fairly fundamental, if the Kaplan book is asking me to know this I am guessing there is a possiblity that an exam will ask me too.”
Well I hope your new tutor can help with your issues. It sounds like it's not the best course though to be fair. Is there no chance you could switch to another course?
All the best with it anyway.
Jayne
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Embersaid:
Well I hope your new tutor can help with your issues. It sounds like it's not the best course though to be fair. Is there no chance you could switch to another course?
All the best with it anyway.
Jayne
”
Hi Jayne
I am currently in negotiations to get a refund on most of what I have paid for so I can start again from scratch. It will cost me more money, but I simply can't face the thought of looking at those files any more. I've looked at the content of anther provider's stuff and it instantly looks so much more user friendly so I will probably be going with them... will have to do level 1 again and unlearn what I did manage to pick up from what the old course taught but it will be worth it in the end I think!
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Hi Evurr,
The accounting aquation only dictates the way a balance sheet should be presented. Capital is equal to assets less liabilities. If your accounting aquation is Assets = capital + liabilities dictates that the balance sheet should be assets at the top and Liabilities and capital or euity at the bottem. It also dictates that Total assets is equal to Capital and liabilities,
Hope this helps
Paula Welsh
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Evurrsaid:
“I don't get this, I feel this should be easy but I just can't get my head round the accounting equation. I can't see how the capital put into a company can equal the assets less the liabilities.
Surely the capital put into the startup of a company remains the same now matter how much profit or loss the company makes.
I get that the company's worth is assets less liabilities.
Can someone give an example, using a storyboard if neccessary to help me understand this?? Use any metaphors or analogies you like, I feel like I need shooting coz I can't understand this....
Thanks”
I too didnt understand this either but after reading the replies especially the ones with examples I now understand, my problem was I was looking at the Capital as an asset instead of money owing to the owner...I keep working on the material and then go back to the begining and start reading again, its all coming together...slowly..LOL
Thank you for posting this question and for all the replies...
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