Every set of accounts, from a market trader’s notebook to a bank’s published statements, rests on one equation. What the business owns is always matched by what it owes to outsiders plus what it owes to its owner. This topic explains that equation, shows how each business transaction changes it, and separates the capital items that last from the revenue items that belong to one year.
In the 20 diets reviewed, Section A carried about one item a diet on this material: the capital of a business, whether an item is an asset or a liability, current assets and working capital, or the profit that follows from opening and closing capital. No Section B question tests it alone, but every question that asks for ledgers or a trial balance from a list of transactions depends on it.
Read FRC Nigeria, bases of accounting and elements of financial statements first, because it defines the terms used here. The next topic turns the equation into double entry.
In 30 seconds
The Accounting equation is Assets = Capital + Liabilities. Assets are resources the entity owns or controls. Liabilities are amounts owed to outsiders. Capital, also called equity, is the owner’s claim, and it is the residual interest in the assets after liabilities are deducted. Every transaction has a Dual effect, so the equation always balances. Profit adds to capital and drawings reduce it: Closing capital = opening capital + profit + capital introduced − drawings.
Capital items are long term and appear in the statement of financial position. Revenue items belong to the year and go to the statement of profit or loss. The business is always treated as separate from its owner.
The accounting equation
The accounting equation is written as Assets = Capital + Liabilities. Rearranged, capital is assets less liabilities, which is the same as the equity of the previous topic. The three terms are the building blocks of the statement of financial position.
- Assets are resources owned by the entity. The Conceptual Framework defines an asset as a present economic resource controlled by the entity as a result of past events (paragraph 4.3).
- Liabilities are what the entity owes. The Framework defines one as a present obligation to transfer an economic resource as a result of past events (paragraph 4.26).
- Capital or equity is the residual interest in the assets after deducting liabilities (paragraph 4.63). It includes the owner’s capital and retained profits. Under the entity concept the capital is treated as owed by the business to its owner.
Capital and liabilities are both claims on the assets. The only difference is who holds the claim: the owner, or an outsider.
Classifying assets and liabilities
| Group | Meaning | Examples |
|---|---|---|
| Non-current assets | Held for use in the business and not for resale | Property, machinery, patent rights |
| Current assets | Expected to turn into cash or be used up within one year | Inventories, trade receivables, cash |
| Non-current liabilities | Obligations due after more than 12 months | Long-term loans, bonds payable |
| Current liabilities | Payable within 12 months of the reporting date | Trade payables, tax liabilities, bank overdrafts |
Working capital is current assets less current liabilities. A prepayment is an asset, because the business has paid for a benefit it has not yet received. It is not a liability, however large the payment.
The entity concept and drawings
The business is treated as separate from its owner, whatever its legal form. When the owner pays cash into the business, the business records capital. When the owner lends money to the business, the business records a liability. The owner’s private home, car and family spending stay out of the records.
Owners can take profit out of the business. Profit left in the business is Retained earnings. Profit taken out is called drawings in a sole proprietorship or partnership, and Dividends in a company. Drawings are usually cash, but they can also be inventory or a non-current asset such as a car.
Whenever the owner takes goods or other assets for private use, the entry is drawings, and it reduces the owner’s equity.
The dual effect of transactions
A business transaction is an interaction between the business and a customer, a supplier or another party that must be recorded. Typical ones are cash and credit sales, receipts from customers, cash and credit purchases, payments to suppliers, loans received and repaid, wages and taxes paid, and the purchase of non-current assets. Each affects the financial statements in two ways, which is the dual effect. That is why the equation always balances.
| Pattern | Example | Assets | Liabilities | Capital |
|---|---|---|---|---|
| One asset up, another asset down | Buy equipment for cash | Net nil | Nil | Nil |
| Asset up, liability up | Buy goods on credit | Up | Up | Nil |
| Asset down, liability down | Pay a supplier | Down | Down | Nil |
| Asset up, capital up | Owner pays cash into the business | Up | Nil | Up |
| Asset down, capital down | Pay rent or take drawings | Down | Nil | Down |
| Asset up, other asset down, capital up | Sell goods at a profit | Up by the profit | Nil | Up by the profit |
Take a sale of goods that cost ₦180,000 for ₦240,000 in cash. Cash rises by ₦240,000 and inventory falls by ₦180,000, so total assets rise by ₦60,000. That is the profit, and capital rises by the same ₦60,000. A credit sale works the same way, except that trade receivables rise instead of cash.
From transaction to financial statements
The accounting equation is a useful way to see what a transaction does, but it is not a practical way to record thousands of them. A business may enter into thousands of transactions in a period, and updating the equation by hand after each one would be inefficient. Every transaction affects the equation in at least two places, with no exceptions.
That dual nature is the basis of double entry. In practice the information passes through a sequence of stages.
- Transactions. The business enters into sales, purchases, receipts, payments and the rest.
- Books of prime entry. This is the first place a transaction is recorded. Instead of entering every sale in the general ledger, a business may summarise the daily sales and post the total. Detailed records for each customer are kept to manage receivables, but they are not part of the general ledger.
- Accounts in the general ledger. The transactions, or the summarised totals, are posted to the relevant accounts.
- Trial balance. A list of the balances is extracted from the ledger as a preliminary step in preparing the statements. It can be taken at any time, but this course assumes it is prepared at the year end.
- Adjustments. The trial balance figures are adjusted for period-end items such as depreciation, accruals and prepayments, bad and doubtful debts and inventory. These are adjustments made directly to the accounts and do not come from actual transactions. Any adjustment made after the trial balance is drawn up must also be recorded in the ledger accounts.
- Financial statements. The statement of profit or loss and the statement of financial position are prepared from the adjusted balances.
At the end of the year there is a major tidying exercise. The balances on the income and expense accounts are transferred to the statement of profit or loss, and the resulting profit or loss is transferred to equity. This resets the income and expense accounts so that the ledger is ready for the next period.
The topics on double entry and the trial balance show each of these steps in detail.
Profit, capital and the change in equity
Income increases equity and expenses reduce it. The difference is profit, which belongs to the owner. Over a period, the movement in capital is:
Closing capital = Opening capital + Profit + Capital introduced − Drawings
This gives a way to find profit when only the capital figures are known: Profit = Closing capital − Opening capital + Drawings − Capital introduced. Capital at each date is found as assets less liabilities. The method is used in the incomplete records topics later in the course, and examiners also use it in Section A.
Suppose a business had assets of ₦4,200,000 and liabilities of ₦1,500,000 at the start of a year, and assets of ₦4,900,000 and liabilities of ₦1,600,000 at the end. Drawings were ₦350,000 and nothing was paid in. Opening capital is ₦2,700,000 and closing capital is ₦3,300,000. Profit = ₦3,300,000 − ₦2,700,000 + ₦350,000 = ₦950,000. Check: ₦2,700,000 + ₦950,000 − ₦350,000 = ₦3,300,000.
Capital and revenue items
A business runs for many years but reports each year. Some of its spending and receipts benefit many years, and others belong only to the current year. They are separated as follows.
| Item | Meaning | Where it goes |
|---|---|---|
| Capital expenditure | Spending to acquire or improve long-term assets, giving benefit beyond the current year. Examples: machinery, furniture, vehicles, installation costs, extensions, fees to raise long-term finance | Statement of financial position, as an asset |
| Revenue expenditure | Day-to-day running costs consumed within the year. Examples: goods for resale, raw materials, rent, electricity, wages, repairs, delivery to customers, accountancy fees | Statement of profit or loss, as an expense |
| Revenue income | Income from normal operations and investments. Examples: sales, commission, interest received, rent received | Statement of profit or loss |
| Capital receipts | Long-term money received, such as a bank loan or new capital from the owner | Statement of financial position only |
Capitalising a cost means recognising it as an asset, or as part of the cost of an asset, instead of as an expense. Capital receipts change the financial position but not the financial performance, so they are left out of the statement of profit or loss. Judgement is sometimes needed to separate capital from revenue expenditure.
Two examples show the line. A business borrows ₦100,000 for five years and pays ₦8,000 interest in the first year. The loan is a non-current liability and a capital receipt, and the interest is revenue expenditure. A business has two identical vehicles with engine faults. Repairing the engine of one is revenue expenditure. Replacing the engine of the other is capital expenditure, because it improves a long-term asset.
Transactions can also be sorted as simple or complex, and as one-off or ongoing. A cash sale of a phone is simple. The same sale on credit may involve instalments and some interest, and a mobile network contract creates a series of payments. The relationship between a business and its bank is the most important ongoing one.
The ideas in more depth
Why the equation must balance
The equation balances because every transaction records both sides of an event. If cash goes out, either another asset comes in, a liability falls, or capital falls. A balance that fails means an effect was missed, which is the reason double entry follows from this topic.
Profit is a change in capital
It is easy to think of profit as cash. It is better seen as a rise in the owner’s claim. A credit sale raises capital through a trade receivable before any cash arrives, and a purchase of equipment lowers cash without lowering capital at all. The difference between profit and cash grows important in the cash flow topics.
Capital is not the same as cash
A business with capital of ₦950,000 does not hold ₦950,000 in the bank. Capital is the owner’s claim on all the net assets, including machinery, stock and receivables.
Drawings are not expenses
Drawings reduce capital directly and do not pass through the statement of profit or loss. Charging them as an expense would understate profit and double-count the reduction in capital.
The line between capital and revenue
The guide is general and not strictly accurate, which is a sensible warning. A cost that adds to the earning capacity or life of an asset is capital, and a cost that merely keeps the asset working is revenue. The topic on non-current assets returns to this.
Sources and references
- International Accounting Standards Board (IASB), Conceptual Framework for Financial Reporting (March 2018): paragraph 4.3 (asset), paragraph 4.26 (liability) and paragraph 4.63 (equity).
Worked example: a tailoring business in Enugu
Scenario. Chiamaka Eze starts a tailoring business in Enugu. All amounts are in ₦’000. (1) She pays in 900 as capital. (2) She borrows 500 from a bank. (3) She buys a sewing machine for 650 in cash. (4) She buys fabric costing 300 on credit. (5) She sells fabric that cost 120 for 200 in cash. (6) She sells fabric that cost 80 for 150 on credit. (7) She pays the supplier 100. (8) A customer pays 90 of the amount owed.
(9) She pays rent of 40 in cash. (10) She takes 60 in cash as drawings. Required: show the effect of each transaction, the closing equation and the profit.
- Capital paid in. Cash 900, capital 900. Assets 900 = capital 900.
- Loan. Cash rises to 1,400 and a loan of 500 appears.
Assets 1,400 = capital 900 + liabilities 500. - Machine. Cash falls to 750 and the machine is 650. Assets stay at 1,400.
- Fabric on credit. Inventory 300 and payables 300.
Assets 1,700 = capital 900 + liabilities 800. - Cash sale at a profit.
Cash 950, inventory 180, capital rises by 200 − 120 = 80 to 980.
Assets: 950 + 650 + 180 = 1,780.
Capital 980 + liabilities 800 = 1,780. - Credit sale.
Receivables 150, inventory 100, capital rises by 150 − 80 = 70 to 1,050.
Assets: 950 + 650 + 100 + 150 = 1,850.
Capital 1,050 + liabilities 800 = 1,850. - Pay supplier. Cash 850, payables 200.
Assets 1,750 = capital 1,050 + liabilities 700. - Customer pays. Cash 940, receivables 60. Total assets stay at 1,750.
- Rent. Cash 900, capital falls by 40 to 1,010.
Assets 1,710 = capital 1,010 + liabilities 700. - Drawings. Cash 840, capital falls by 60 to 950.
Assets 1,650 = capital 950 + liabilities 700. - Closing position.
Assets: cash 840 + receivables 60 + inventory 100 + machine 650 = 1,650.
Liabilities: loan 500 + payables 200 = 700.
Capital = 1,650 − 700 = 950. - Profit.
Sales profits 80 + 70 = 150, less rent 40 = 110.
Check: opening capital 900 + profit 110 − drawings 60 = 950, which agrees with the closing capital.
The same example in tabular accounting equation form (₦’000)
The equation can also be shown as a table, with one row for each transaction and the running totals on each side. The totals must agree on every row.
| After transaction | Cash | Receivables | Inventory | Machine | Assets | Capital | Loan | Payables | Capital + liabilities |
|---|---|---|---|---|---|---|---|---|---|
| 1 | 900 | 900 | 900 | 900 | |||||
| 2 | 1,400 | 1,400 | 900 | 500 | 1,400 | ||||
| 3 | 750 | 650 | 1,400 | 900 | 500 | 1,400 | |||
| 4 | 750 | 300 | 650 | 1,700 | 900 | 500 | 300 | 1,700 | |
| 5 | 950 | 180 | 650 | 1,780 | 980 | 500 | 300 | 1,780 | |
| 6 | 950 | 150 | 100 | 650 | 1,850 | 1,050 | 500 | 300 | 1,850 |
| 7 | 850 | 150 | 100 | 650 | 1,750 | 1,050 | 500 | 200 | 1,750 |
| 8 | 940 | 60 | 100 | 650 | 1,750 | 1,050 | 500 | 200 | 1,750 |
| 9 | 900 | 60 | 100 | 650 | 1,710 | 1,010 | 500 | 200 | 1,710 |
| 10 | 840 | 60 | 100 | 650 | 1,650 | 950 | 500 | 200 | 1,650 |
Common mistakes in the exam
- Treating a prepayment as a liability. It is an asset.
- Recording a sale as a rise in capital of the full selling price. Only the profit adds to capital, and the cost of the goods leaves inventory.
- Charging drawings as an expense of the business.
- Calling a bank loan capital. It is a liability. Only the owner’s funds are capital.
- Putting a bank overdraft among assets, or among non-current liabilities when it is payable on demand.
- Forgetting to deduct capital introduced when finding profit from capital figures, or forgetting to add back drawings.
- Calling a repair capital expenditure, or the replacement of a major part a revenue expense.
Quick revision
- Assets = Capital + Liabilities. Capital = assets − liabilities.
- Non-current assets last. Current assets turn to cash within a year. Current liabilities are due within 12 months.
- Working capital = current assets − current liabilities.
- Every transaction has a dual effect, so the equation always balances.
- Closing capital = opening capital + profit + capital introduced − drawings.
- Drawings (sole traders, partners) and dividends (companies) reduce equity.
- Capital expenditure and capital receipts go to the statement of financial position. Revenue items go to the statement of profit or loss.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.
Section A style: multiple choice
Question 1. A business has assets of ₦920,000 and liabilities of ₦380,000. Its capital is:
- ₦540,000
- ₦380,000
- ₦920,000
- ₦1,300,000
Show the answer
A. Capital = assets − liabilities = ₦920,000 − ₦380,000 = ₦540,000.
Question 2. The owner pays ₦300,000 from a private account into the business bank account. The effect is:
- Assets up and liabilities up
- Assets down and capital down
- No change in the equation
- Assets up and capital up
Show the answer
D. Cash rises and the owner’s claim, capital, rises by the same amount.
Question 3. A business buys equipment for ₦200,000 on credit. The effect is:
- Assets up ₦200,000 and capital up ₦200,000
- Assets up ₦200,000 and liabilities up ₦200,000
- Assets down ₦200,000 and liabilities down ₦200,000
- No effect on total assets
Show the answer
B. The equipment is an asset and the amount owed is a liability.
Question 4. A business pays a trade payable ₦90,000 in cash. The effect is:
- Assets fall and capital falls by ₦90,000
- Liabilities rise by ₦90,000
- No change in either
- Assets and liabilities both fall by ₦90,000
Show the answer
D. Cash falls and so does the amount owed.
Question 5. Goods costing ₦40,000 are sold for ₦65,000 in cash. The effect on capital is:
- An increase of ₦40,000
- An increase of ₦25,000
- An increase of ₦65,000
- No change
Show the answer
B. Capital rises by the profit: ₦65,000 − ₦40,000 = ₦25,000.
Question 6. An owner takes inventory costing ₦15,000 for personal use. This is recorded as:
- An expense of the business
- A sale
- Drawings, which reduce capital
- An increase in liabilities
Show the answer
C. Assets taken for private use are drawings.
Question 7. A bank overdraft is classified as:
- A non-current asset
- A current asset
- A current liability
- Capital
Show the answer
C. It is an obligation repayable within 12 months.
Question 8. Which of the following is capital expenditure?
- Wages of the sales staff
- Repair of a delivery van’s engine
- Electricity for the office
- Installation costs of a new machine
Show the answer
D. Installation costs are part of the cost of the machine, a long-term asset. The others are revenue expenditure.
Question 9. Opening capital was ₦500,000 and closing capital ₦560,000. Drawings were ₦70,000 and no capital was introduced. Profit for the year was:
- ₦130,000
- ₦60,000
- ₦560,000
- ₦630,000
Show the answer
A. ₦560,000 − ₦500,000 + ₦70,000 = ₦130,000.
Question 10. A customer pays ₦50,000 owed on credit. The effect is:
- Cash up and receivables down by the same amount
- Cash up and capital up
- Receivables up and capital up
- Liabilities down
Show the answer
A. One asset replaces another, and total assets do not change.
Section B style: written questions
Question 11 (10 marks). (a) State the accounting equation and define each term in it. (4 marks) (b) Distinguish capital expenditure from revenue expenditure and give TWO examples of each. (4 marks) (c) Give ONE example of a capital receipt and explain why it is not in the statement of profit or loss. (2 marks)
Question 12 (20 marks). Kabiru Danladi opens a provisions store in Kano. All amounts are in ₦’000. (1) He pays in 1,200 as capital. (2) He buys shop fittings for 400 in cash. (3) He buys goods costing 500 on credit. (4) He sells goods that cost 300 for 450 in cash. (5) He pays the supplier 250. (6) He takes goods costing 30 and cash of 20 for private use. (7) He pays wages of 70 in cash. (8) He receives a loan of 600.
(a) Show the accounting equation after each transaction. (10 marks)
(b) State the closing assets, liabilities and capital, and calculate the profit for the period. (4 marks)
(c) Classify the shop fittings, the wages, the loan and the sale as capital expenditure, revenue expenditure, capital receipt or revenue income. (4 marks)
(d) State the treatment of transaction (6) and explain why. (2 marks)
A further written question
Question 13 (10 marks). At the start of a year a trader had assets of ₦8,400,000 and liabilities of ₦3,100,000. At the end of the year the assets were ₦9,650,000 and the liabilities ₦3,450,000. Drawings were ₦640,000 and no capital was introduced. (a) Calculate the opening capital, the closing capital and the profit for the year. (6 marks) (b) Explain why profit can be found this way and state ONE weakness of the method. (4 marks)
Model answers
Show the model answer to Question 11
(a) Assets = Capital + Liabilities. Assets are resources the entity owns or controls. Liabilities are amounts owed to outsiders. Capital, or equity, is the owner’s claim, the residual interest in the assets after deducting liabilities.
(b) Capital expenditure is spending to acquire or improve long-term assets that benefit more than one year, and it is shown in the statement of financial position. Examples: buying machinery, installing air conditioning. Revenue expenditure is day-to-day running cost consumed within the year, and it is an expense in the statement of profit or loss. Examples: wages, electricity, repairs.
(c) A bank loan, or new capital paid in by the owner, is a capital receipt. It changes the financial position, as an increase in cash and in a liability or capital, but it is not income earned from trading, so it is left out of the statement of profit or loss.
Show the model answer to Question 12
(a) Equation after each transaction (₦’000).
- Cash 1,200 = capital 1,200.
- Cash 800 + fittings 400 = 1,200 = capital 1,200.
- Cash 800 + fittings 400 + inventory 500 = 1,700 = capital 1,200 + payables 500.
- Cash 1,250 + fittings 400 + inventory 200 = 1,850 = capital 1,350 + payables 500.
Capital rose by the profit 450 − 300 = 150. - Cash 1,000 + fittings 400 + inventory 200 = 1,600 = capital 1,350 + payables 250.
- Cash 980 + fittings 400 + inventory 170 = 1,550 = capital 1,300 + payables 250.
Drawings of 50 reduced capital. - Cash 910 + fittings 400 + inventory 170 = 1,480 = capital 1,230 + payables 250.
Wages reduced capital by 70. - Cash 1,510 + fittings 400 + inventory 170 = 2,080 = capital 1,230 + payables 250 + loan 600 = 2,080.
(b)
- Closing assets 2,080, liabilities 850 (payables 250 and loan 600), capital 1,230.
- Profit = gross profit 150 − wages 70 = ₦80,000.
- Check.
1,200 + 80 − 50 = 1,230.
(c) Shop fittings: capital expenditure. Wages: revenue expenditure. Loan: capital receipt. Sale: revenue income.
(d) Transaction (6) is drawings of ₦50,000 (goods 30 and cash 20). The owner took business assets for private use, so it reduces capital and is not an expense of the business.
Show the model answer to Question 13
(a)
- Opening capital.
₦8,400,000 − ₦3,100,000 = ₦5,300,000. - Closing capital.
₦9,650,000 − ₦3,450,000 = ₦6,200,000. - Profit = closing capital − opening capital + drawings = ₦6,200,000 − ₦5,300,000 + ₦640,000 = ₦1,540,000.
- Check.
₦5,300,000 + ₦1,540,000 − ₦640,000 = ₦6,200,000.
(b) Profit is the amount by which the owner’s claim grew after allowing for what the owner took out and paid in. The owner took out ₦640,000, so the increase of ₦900,000 understates profit by that amount. One weakness is that the method shows only the total profit.
It does not show the revenue and expenses that produced it, so it gives no detail for the statement of profit or loss and cannot reveal which costs were too high.
Pathfinder on The accounting equation and business transactions
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Question 3 asks for the capital of a business from its assets, loan and payables. Question 4 asks for liabilities as a percentage of assets.
Revise first: The accounting equation
From the previous syllabus. Asks which item does not belong to the same group in asset classification.
Revise first: The accounting equation
From the previous syllabus. Asks for profit or loss from opening capital, closing capital and the owner’s withdrawals.
Revise first: Profit, capital and the change in equity
From the previous syllabus. Asks for current assets and for working capital from given figures.
Revise first: The accounting equation
From the previous syllabus. Asks which item is a current liability in a set of club accounts.
Revise first: The accounting equation
From the previous syllabus. Asks which statement is not correct about the definition of assets.
Revise first: The accounting equation
From the previous syllabus. Asks which of five items is not a liability. The same item appears in both diets.
Revise first: The accounting equation
Asks for profit from total assets and total liabilities at two year ends and additional capital paid in.
Revise first: Profit, capital and the change in equity
About one item a diet tests this topic. No Section B question tests it alone, but questions that ask for ledgers or a trial balance from a list of transactions rest on it. Check Section A of every diet you practise.
Revise first: The dual effect of transactions
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2015, November Diet, 2016, May Diet, 2018, November Diet, 2019, March/July Diet, 2020, May Diet, 2021, November Diet, 2021, November Diet, 2022 and May Diet, 2024 (all previous syllabus). Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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