This chapter introduces one of the most important foundations in accounting: the accounting equation. It explains how all financial transactions affect a business's position through this equation and introduces its key components of assets, liabilities, and capital. It also explores the main types of business entities — sole traders, partnerships, and companies — and how the business structure impacts financial reporting.

By the end of this chapter, you will be able to:

• Understand the components of the accounting equation.
• Apply the double-entry bookkeeping principle — that every transaction has two effects.
• Define and give examples of assets, liabilities, and capital.
• Explain the differences between sole traders, partnerships, and companies.
• Recognise how the accounting equation underpins the structure of financial statements.

Core concepts include:

• The accounting equation: Assets = Liabilities + Capital
• The dual nature of financial transactions
• The definitions and roles of assets, liabilities, and capital
• Capital and drawings in a sole trader context
• Equity in a company context
• Key characteristics of sole traders, partnerships, and companies

The accounting equation is the central idea behind bookkeeping. It states that:

Assets = Liabilities + Capital

This means that everything a business owns (its assets) is funded by either money it owes to others (its liabilities) or by the owner's own investment in the business (capital). The equation must always balance — every transaction affects at least two parts of the equation in a way that keeps it in balance.

For example, if a business takes out a £5,000 bank loan, its cash (asset) increases by £5,000, and its liabilities increase by £5,000. Both sides of the equation go up equally.

Let's look at each component of the equation in more detail:

• Assets are present economic resources controlled by a business as a result of past events, from which future economic benefits are expected to flow. Examples include cash, inventory, trade receivables (amounts owed by customers), and equipment.

○ Non-current assets: Long-term assets held for more than one year, such as buildings, vehicles, and machinery. These are used in operations, not for resale.

○ Current assets: Short-term assets expected to be converted into cash within a year, such as inventory, trade receivables, and cash.

• Liabilities are present obligations of a business arising from past events, the settlement of which is expected to result in an outflow of economic resources. Examples include trade payables (amounts owed to suppliers), bank loans, and tax liabilities.

○ Non-current liabilities: Debts due after more than one year, such as long-term loans or mortgages.

○ Current liabilities: Debts due within a year, such as trade payables, short-term loans, or accrued expenses.

• Capital (also called equity) represents the residual interest in the assets of a business after deducting its liabilities. It reflects the owner's investment in the business, adjusted for profits retained or withdrawn (by way of drawings or dividends).

Every transaction in accounting has two effects — this is known as the double-entry bookkeeping principle. For example:

• Buying inventory with cash reduces one asset (cash) and increases another (inventory).
• Taking out a loan increases cash (asset) and also increases liabilities.
• Earning income increases cash (or receivables) and also increases capital (via profit).

Because of this double-entry, the accounting equation always remains balanced.

Example: A business is started with £10,000 cash from the owner.

• Cash (asset) increases by £10,000.
• Capital increases by £10,000.

Now the accounting equation is:

Assets (£10,000) = Liabilities (£0) + Capital (£10,000)

The accounting equation forms the basis of the statement of financial position (also called the balance sheet). This statement shows:

• What the business owns (assets)
• What it owes (liabilities)
• What belongs to the owner(s) (capital or equity)

Here's a simplified example:

The top (assets) always equals the bottom (liabilities + capital), because of the accounting equation.