Elements & the Accounting Equation
Financial statements are built from assets, liabilities, equity, income and expenses. The accounting equation connects these elements and remains balanced after every business transaction.
1. Elements of financial statements
Assets are resources belonging to or controlled by a business that generate future benefits. Current assets include cash, inventory and trade receivables; non-current assets include buildings, fixtures and machinery.
Liabilities are obligations owed to external parties. Current liabilities include trade payables, overdrafts and short-term loans; non-current liabilities include long-term and mortgage loans.
Equity is the owner's net interest. Income and profits increase equity; expenses and losses reduce it. For sole proprietors, capital increases equity and drawings reduce it. For companies, share capital and retained earnings increase equity while dividends and accumulated losses reduce it.
2. Income and expenses
A trading business earns its main revenue from sales; a service business earns service revenue. Commission, discount received, gains, interest and rental income can be other income. Expenses are costs incurred in earning revenue and other income.
3. Accounting equation
Basic equation: Assets = Liabilities + Equity
For a sole proprietor: Assets = Liabilities + Capital + Income − Expenses − Drawings. For a private limited company, capital and drawings are replaced by share capital and dividends.
Every business transaction affects two or more elements, but the equation remains balanced. A transaction can also exchange one asset for another without changing total assets.
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