Part C The use of double
entry and accounting systems
5: Ledger accounts and double entry
75
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
76
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