Acca f3 Financial Accounting (int) Study Text

Part C  The use of double entry and accounting systems

  5:  Ledger accounts and double entry

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The accounting equation is: 

ASSETS = CAPITAL + LIABILITIES 

For Liza Doolittle, as at 1 July 20X6: 

Assets___=_Capital___+_Liabilities'>Assets

= Capital 

+ Liabilities 

$2,500 (cash)

= 

$2,500 

+ 

$0 

3.2 Example continued 

Liza Doolittle purchases a market stall from Len Turnip, who is retiring from his fruit and vegetables 

business. The cost of the stall is $1,800. 

She also purchases some flowers and potted plants from a trader in the wholesale market, at a cost 

of $650. This leaves $50 in cash, after paying for the stall and goods for resale, out of the original $2,500.

The assets and liabilities of the business have now altered, and at 3 July before trading begins, the state of 

her business is as follows. 

Assets

 = 

Capital

+

Liabilities

$    

 

 

 

Stall 1,800 

= 

$2,500 

+ 

$0 

Flower and plants 

650   

 

 

 

Cash

    50

 

 

2,500

The stall and the flowers and plants are physical items, but they must be given a money value. This money 

value is usually what they cost the business (called 

historical cost in accounting terms). 

3.3 Profit introduced into the accounting equation 

On 3 July Liza has a very successful day. She sells all of her flowers and plants for $900 cash. 

Since Liza has sold goods costing $650 to earn revenue of $900, we can say that she has 

earned a profit 

of $250 on the day's trading.

Profits belong to the owners of a business. In this case, the $250 belongs to Liza Doolittle. However, so 

long as the business retains the profits and does not pay anything out to its owners, the 

retained profits 

are accounted for as an addition to the proprietor's capital. 

Assets

=

Capital

+

Liabilities

$        

 

$        

 

Stall

1,800   Original 

investment 

2,500  

 

Flower and plants 

0   

Retained profit 

   

 

Cash (50 + 900) 

   950   

   (900 – 650) 

   250

2,750

2,750

+ $0 

We can re-arrange the accounting equation to help us to calculate the capital balance. 

Assets – liabilities 

= 

Capital, which is the same as 

Net assets 

= 

Capital 

At the beginning and end of 3 July 20X6, Liza Doolittle's financial position was as follows. 

Net assets 

Capital

(a) 

At the beginning of the day:  $(2,500 – 0) = $2,500 = 

$2,500

(b) 

At the end of the day: 

$(2,750 – 0) = $2,750 = 

$2,750

There has been an increase of $250 in net assets, which is the amount of profits earned during the day. 

Formula to 

learn

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5: Ledger accounts and double entry   Part C  The use of double entry and accounting systems 

3.4 Drawings 

Drawings are amounts of money taken out of a business by its owner. 

Since Liza Doolittle has made a profit of $250 from her first day's work, she might want to withdraw some 

money from the business. After all, business owners, like everyone else, need income for living expenses. 

Liza decides to pay herself $180 in 'wages'. However, the $180 is not an expense to be deducted in 

arriving at the figure of net profit. In other words, it is incorrect to calculate the net profit earned by the 

business as follows. 

$

Profit on sale of flowers etc 

250

Less 'wages' paid to Liza

180

Net profit earned by business (incorrect)

  70

This is because any amounts paid by a business to its proprietor are treated by accountants as 

withdrawals of profit (the usual term is 

drawings) and not as expenses incurred by the business. In the 

case of Liza's business, the true position is that the net profit earned is the $250 surplus on sale of 

flowers.

$

Net profit earned by business 

250

Less profit withdrawn by Liza

180

Net profit retained in the business

  70

Profits are capital as long as they are retained in the business. Once they are 

withdrawn, the business 

suffers a reduction in capital. 

The withdrawals of profit are taken in cash, and so the business loses $180 of its cash assets. After the 

withdrawals have been made, the accounting equation would be restated. 

(a)

Assets

 = 

Capital

 + 

Liabilities

 

 

$        

 

  $        

 

 Stall 

1,800 

 Original 

investment 

2,500 

 

 

 

Flowers and plants 

0   

Retained profit  

   

 

Cash (950 – 180)

   770

  (250 – 180)

     70

2,570

2,570

+ $0 

(b) Alternatively  Net assets 

 

Capital 

 

$(2,570 – 0)  = 

 

$2,570 

The increase in net assets since trading operations began is now only $(2,570 – 2,500) = $70, which is the 

amount of the retained profits. 

Question 

Capital

Which of the following is correct? 

A 

Capital = assets + liabilities 

B 

Capital = liabilities – assets 

C 

Capital = assets – liabilities 

D 

Capital + assets = liabilities 

Answer

The correct answer is C. As assets = liabilities + capital, then capital = assets – liabilities 

Key term 

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