Unit 1 Fundamentals of Accounting
Text 1.2 The Accounting equation
Skim and scan
(a) Was progress in accountancy quick or slow in the past?
(b) What does a balance sheet represent?
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Accounting is at least the second oldest profession in the world. But while earlier professionals rapidly got to grips with basic techniques and even introduced refinements, it is remarkable that generations of tax collectors and merchants staggered on for thousands of years before finding a satisfactory general method of keeping a record of their affairs.
This should serve as a warning. The problem is common sense but the answer is not. It is highly contrived and in some respects still imperfect. It begins with a particular way of looking at a business which we present in the next section.
A business may be pictured as a box. The box has contents and by virtue of owning the box, the owner has a claim to the value of thecontents. Others also may have |a claim on the contents, by virtue of having lent money to the business or of having supplied goods or services to the business for which they have not yet been paid. These are the creditors of the business.
As the business buys and sells goods and services, so the value of the contents of the box will increase or decrease, depending on whether the business makes a profit or a loss. These changes in value of contents must be equalled by changes in value of claims on contents. Specifically the claims of the owners will vary so that the total value of claims is always equal to the value of the contents.
Now we ma у list the value ofthe contents of the business box at any time, say down the left side of a piece of paper. On the right side we may list the value of claims on those contents. The claims of third party creditors will be known. The claims of the owners will amount to whatever is necessary to make the total value of claims equal to the total value of contents.
Such a list of contents (on the left) balanced by a list of claims (on the right), constitutes a simple balance sheet. A balance sheet is a presentation of the state of affairs of a business in a succinct, systematic and recognizable format.
Restating the original theory, with the picture of the business as a box, we can write
£ contents = £ claims on contents.
In accounting terms, this becomes
(1) ASSETS = EQUITY + LIABILITIES
where assets are simply what is held in the business, equity is the claim of the owners, and liabilities are the claims of third parties.
By transferring liabilities to the other side of the equation we may write
ASSETS - LIABILITIES = EQUITY
or, using a technical term
(2) NET ASSETS = EQUITY
Finally we may split equity into the capital originally put into the business and reserves. Reserves represent profits which have been reserved or kept in the business. The equation now becomes
(3) NET ASSETS = CAPITAL + RESERVES
1, 2 and 3 above are forms of the fundamental accounting equation.
'Management in English Language Teaching’, White, R. et al. (Cambridge University Press, 1991)
