Financial Accounting · Lesson 3

The accounting equation, double entry and ledger classification

JAMBWAECNECO

What the syllabus asks

JAMB: Topic 2 Principles of double entry (c) the accounting equation, (d) the ledger and its classifications, balancing of accounts

WAEC: Accounting equation and double-entry principles; ledger: classification of accounts, posting and balancing

NECO: Accounting equation and double-entry principles; ledger: classification of accounts, posting and balancing

What you will learn

State and use the accounting equation, including the expanded form.
Show the effect of transactions on assets, liabilities and capital.
Explain the duality concept and the rules of double entry.
Classify accounts as personal, real or nominal, and as asset, liability, capital, income or expense.
Post transactions to the correct sides of ledger accounts.
Balance off ledger accounts and interpret the balance.
Name the divisions of the ledger.

Key points

Assets = Capital + Liabilities, after every transaction.
Expanded: Assets + Expenses + Drawings = Capital + Liabilities + Income.
Duality: every debit has an equal credit.
DEAD CLIC: Debit Expenses, Assets, Drawings; Credit Liabilities, Income, Capital.
Golden rules: personal (Dr receiver, Cr giver), real (Dr what comes in, Cr what goes out), nominal (Dr expenses/losses, Cr incomes/gains).
Purchases and sales relate only to goods for resale.
Balance c/d on the smaller side; balance b/d on the opposite side.
Ledger divisions: sales, purchases, general (nominal), cash book.
Bank account with credit balance = overdraft; cash account cannot have a credit balance.

Start here: The accounting equation

Every business, whether a provisions shop in Onitsha main market or a bank in Lagos, has resources it uses (assets) and claims on those resources. The claims come from two groups: the owner, whose claim is called capital, and outsiders such as suppliers and lenders, whose claims are called liabilities. Because every naira of resources must have come from somewhere, the resources always equal the claims:

Assets = Capital + Liabilities

This is the accounting equation (also called the balance sheet equation). It can be rearranged: Capital = Assets − Liabilities, and Liabilities = Assets − Capital. In examinations you will often be given two of the three and asked for the third.

Meaning of the three elements

Assets are resources controlled by the business that are expected to bring future benefits. Non-current (fixed) assets are held for long-term use: land, buildings, motor vehicles, furniture, machinery. Current assets are held for a short time or converted into cash within a year: inventory (stock), trade receivables (debtors), prepayments, bank and cash.
Liabilities are amounts the business owes. Current liabilities fall due within a year: trade payables (creditors), bank overdraft, accrued expenses. Non-current liabilities are due after more than a year: long-term bank loans, debentures (loan notes).
Capital (equity, owner’s equity, net worth) is what the business owes the owner. It increases when the owner puts in more resources or the business earns a profit, and it decreases when the owner takes drawings or the business makes a loss.

Because of the business entity concept (fa1), capital is treated as a claim against the business, even for a sole trader who legally owns everything. That is why capital sits on the same side as liabilities.

Worked example 3.1 (illustrative)

Halima’s tailoring shop in Kano has sewing machines ₦420 000, inventory of fabric ₦180 000, cash ₦55 000 and receivables ₦45 000. She owes suppliers ₦95 000 and has a bank loan of ₦200 000. Find her capital.

Solution: Assets = 420 000 + 180 000 + 55 000 + 45 000 = ₦700 000. Liabilities = 95 000 + 200 000 = ₦295 000. Capital = 700 000 − 295 000 = ₦405 000.

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Practice questions

1. The accounting equation is

Assets = Capital + Liabilities
Assets = Capital − Liabilities
Capital = Assets + Liabilities
Liabilities = Assets + Capital

Show answer

A: Assets = Capital + Liabilities
Every asset is financed by the owner or by outsiders.

2. Paying a creditor by cheque will

increase assets and liabilities
reduce capital
leave liabilities unchanged
reduce assets and reduce liabilities

Show answer

D: reduce assets and reduce liabilities
Bank (asset) falls and payables (liability) fall.

3. The owner brings in ₦200 000 cash as additional capital. The entry is

Dr Cash, Cr Sales
Dr Drawings, Cr Cash
Dr Cash, Cr Capital
Dr Capital, Cr Cash

Show answer

C: Dr Cash, Cr Capital
Cash rises (debit); capital rises (credit).

4. Rent paid in cash is recorded as

Dr Capital, Cr Rent
Dr Rent, Cr Cash
Dr Cash, Cr Rent
Dr Rent, Cr Capital

Show answer

B: Dr Rent, Cr Cash
Expenses are debited; cash going out is credited.

5. Goods sold on credit to Bayo are recorded as

Dr Bayo, Cr Sales
Dr Sales, Cr Bayo
Dr Cash, Cr Sales
Dr Bayo, Cr Purchases

Show answer

A: Dr Bayo, Cr Sales
Bayo becomes a debtor (debit); sales income is credited.

Key words

Accounting equation: Assets = Capital + Liabilities; the statement that resources equal claims on them.
Asset: A resource controlled by the business from which future economic benefits are expected, e.g. cash, inventory, vehicles.
Liability: A present obligation of the business to transfer resources, e.g. trade payables, loans.
Capital (equity): The owner’s interest in the business: assets less liabilities.
Drawings: Cash, goods or other assets taken by the owner for private use.
Double entry: The system of recording each transaction twice: a debit in one account and an equal credit in another.
Duality concept: The idea that every transaction has two equal and opposite aspects.
Ledger: The principal book of accounts containing all the individual accounts.
Account: A record in the ledger of all transactions relating to one item, person or class of income or expense.
Debit (Dr): The left-hand side of an account.
Credit (Cr): The right-hand side of an account.
T-account: The traditional two-sided format of an account, shaped like the letter T.

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