Accounting Principles

Assets and Liabilities

Assets and liabilities are what your business owns and owes.

An asset is something valuable which a business owns or has the use of, such as factories, office buildings, vehicles, computers, stock and so on.

A liability is something which is owed to somebody else. A liability is a debt of the business, such as a bank loan or overdraft, amounts owed to suppliers or taxation owed to the government.

Capital is a special liability. Capital the money that the owners put into a business, with the intention of earning a return. Therefore, capital is money that is owed to the owners by the business.

Assets in the balance sheet are divided into Fixed Assets and Current Assets.

Fixed Assets

Fixed assets must be used by the business.  So you would not normally expect the family home on the balance sheet.  The asset must also have a “life” of more than year, (well, strictly speaking, more than one accounting period, which may be longer or shorter a calendar year)

Fixed assets, for balance sheet purposes, are further divided into:

• tangible fixed assets (eg. plant, machinery, vehicles and so on – things that can be touched)
• intangible fixed assets (eg. goodwill, brands – things that aren’t physical)
• investments (long term) (eg. property held for investment, shares in another company)

Fixed assets must also be depreciated.  That is, their value needs to be reduced every year to show that it is being “used up”.  (Depreciation will be the subject of a future blog).

Current Assets

These can be things like:

• stock
• debtors
• cash, which includes money in the bank
• prepayments (which are amounts of money paid in advance, by the business)
• short-term investments

Liabilites

A liability is a debt that a business or person owes.  (A creditor is a liability, because they are owed money)

A current liability is a debt that must be paid within a fairly short period of time.  In balance sheet terms, this is generally accepted as a debt that is repayable within a year.

These include things like:

• loans repayable within one year
• a bank overdraft
• trade creditors
• tax
• accrued charges (debts for which the business has not yet received an invoice for)

A long-term liability is any other debt (which is not due within one year).  Examples of long-term liabilities would be:

• long term loans
• mortgages
• debentures or debenture loans (securities issued by a limited company at a fixed rate of interest)

The Accounting Equation

The Accounting Equation is:

Assets – Liabilities = Capital

which is the same as:

Net Assets = Captial.

For example, Tina T invests £1,200 in her business.
Therefore, the business has:
Assets of £1,200 (because the money has now become an asset of the business).
Liabilities of £1,200 Capital and no other liabilities.

So, the accounting equation is quite simply:  £1,200 (assets) = £1,200 (capital)

Accounting Equation with profit

If Tina buys a stall for £1,000; has cash sales of £400 and the goods had cost £200.  Tina has earned a profit of £200.

The accounting equation would then be:

£1,000 (asset of the stall) + £400 (asset, cash from the sales) = £1,200 (original capital) + £200 (profit retained in the business)