1.2 The accounting equation (3)
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1.
Explain how the accounting equation is affected by the following transactions. Show your calculations.
- The business purchases office equipment for £3,000 on credit.
- The business receives £2,000 cash from a customer for goods sold on credit.
- The business pays £500 cash to suppliers for goods previously purchased on credit.
Transaction 1: Purchase of office equipment on credit (£3,000)
Effect on Accounting Equation:
- Assets (Equipment) increase by £3,000.
- Liabilities (Accounts Payable) increase by £3,000.
- Equity remains unchanged.
Equation:** Assets = Liabilities + Equity. The increase in both assets and liabilities maintains the balance.
Transaction 2: Cash received from customer (£2,000)
Effect on Accounting Equation:
- Assets (Cash) increase by £2,000.
- Liabilities remain unchanged.
- Equity increases by £2,000.
Equation:** Assets = Liabilities + Equity. The increase in assets and equity is balanced by no change in liabilities.
Transaction 3: Payment to suppliers (£500)
Effect on Accounting Equation:
- Assets (Cash) decrease by £500.
- Liabilities (Accounts Payable) decrease by £500.
- Equity remains unchanged.
Equation:** Assets = Liabilities + Equity. The decrease in both assets and liabilities maintains the balance.
2.
Explain why it is important for a business to accurately distinguish between assets, liabilities, and owner's equity. Consider the implications for stakeholders.
Accurately distinguishing between assets, liabilities, and owner's equity is crucial for several reasons, impacting various stakeholders:
- Financial Health Assessment: The distinction allows stakeholders (investors, lenders, management) to assess the financial health and solvency of the business. A healthy business typically has more assets than liabilities and a strong owner's equity position.
- Decision Making (Investors): Investors use this information to decide whether to invest in the business. A positive owner's equity suggests a lower risk of financial loss.
- Creditworthiness (Lenders): Lenders assess a business's ability to repay loans based on its liabilities and equity. A strong equity position increases the likelihood of loan approval and favorable terms.
- Profitability Analysis (Management): Management uses this information to understand the company's financial position and make informed decisions about resource allocation, investment, and risk management. It helps in evaluating the effectiveness of business strategies.
- Transparency and Compliance: Accurate classification is essential for preparing financial statements that comply with accounting standards (like IFRS or UK GAAP). This ensures transparency and accountability to stakeholders.
- Business Valuation: The difference between assets and liabilities (owner's equity) is a key component in determining the overall value of the business.
In summary, accurate classification provides a clear picture of the business's financial position, enabling informed decision-making by all stakeholders and ensuring transparency in financial reporting.
3.
A company has the following information as of December 31, 2023:
- Cash: £15,000
- Accounts Receivable: £8,000
- Inventory: £12,000
- Equipment: £25,000
- Accounts Payable: £5,000
- Loan Payable: £10,000
- Capital: £20,000
Calculate the company's owner's equity. Show your working.
To calculate owner's equity, we first need to determine the total assets and the total liabilities.
| Cell |
| Assets | £15,000 + £8,000 + £12,000 + £25,000 = £60,000 |
| Liabilities | £5,000 + £10,000 = £15,000 |
| Owner's Equity | £60,000 - £15,000 = £45,000 |
Therefore, the company's owner's equity is £45,000.