Karen Groves explains a subject area that all AAT studiers really need to be on top of.
Double entry bookkeeping starts from what is known as the accounting equation. For each business transaction there will be two financial effects, known as the dual effect principle.
For accounting purposes, the business owner is separate from the business itself, which is known as the separate entity principle. If the owner invests money into the business, this is shown as capital introduced and then becomes a liability for the business, as the business then owes the owner the money.
The accounting equation shows how the money invested by the owner/s will equal the assets of the business. For example, the business owner may borrow some money to set up a new business, which is referred to as a liability, and can be shown as:
ASSETS = LIABILITIES + CAPITAL
The equation can also be re-arranged as follows:
ASSETS – LIABILITIES = CAPITAL
Example
The owner of the business has invested £6,000 of their own money and paid this into the business bank account. The equation would show:
ASSETS (BANK) £6,000 = CAPITAL £6,000
If the owner then borrowed £2,000 for a business loan, which was paid into the bank, the equation would show:
ASSETS (BANK) £8,000 – LIABILITY (LOAN) £2,000 = CAPITAL £6,000
The above shows that the equation will always balance, and assets must equal liabilities.
Profit will also increase the owner’s capital account and any drawings the owner takes, will reduce this. The equation can be shown as:
ASSETS – LIABILITIES = CAPITAL + PROFIT – DRAWINGS
What are assets, liabilities, capital and drawings?
Assets are owned and controlled by the business and can include:
- Receivables (money owed by customers)
- Plant and machinery
- Delivery vehicles
- Inventory
- Cash and Bank balance (if bank positive)
Liabilities are owed by the business and can include:
- Loans
- Payables (money owed to suppliers)
- Liabilities owed for VAT or tax.
- Bank balance (if overdrawn)
Capital can relate to money or assets invested by the business owner. These can include cash, vehicles, office equipment and so on. The amount is owed back to the business owner and therefore is a liability of the business.
Drawings are money or goods taken from the business by the owner for their own use.
Test your knowledge
Identify if the following items are assets or liabilities:
Answer
- Karen Groves is an AAT tutor and Faculty Director of Accounting at e-Careers
