As an introduction to this chapter, it is helpful to begin with sorne definitions. The definitions of what constitutes an asset, liability, capital, income and expense bring consistency to how accounting transactions are recorded, classified and summarised. This helps to provide a foundation for the preparation of the trial balance and, ultimately, the financial statements. In order to report the financial performance and financial position of a business the financial statements must summarise the five key elements. The statement of financial position consists of assets, liabilities and capital which are, in effect, the accounting equation (see later in this chapter). The statement of profit or loss consists of income and expenses.
An asset is a present economic resource which the business controls as a result of a past event. It is used to generate future economic benefits for a business. An asset could either be sold for cash or could help the business to generate income and profits. Examples of an asset used to generate future economic benefits is plant and equipment used by a business to produce goods to sell to customers, or inventory held for sale to customers.
A liability is a present obligation to transfer an economic resource as a result of a past event. This could be a bank loan or overdraft outstanding, or amounts owed to suppliers for goods and services received but not yet paid for.
Equity or capital is the amount due to the owner of a business after all liabilities have been paid. The owner has the residual interest in the assets of the business after all liabilities have been settled. The term 'equity' is normally used in relation to a limited company , whereas 'capital' is the term normally used for an unincorporated business such as a sole proprietor or a partnership.
Income arises through increases in assets or decreases in liabilities that result in an increase in equity or capital, other than changes relating to contributions from the business owners in the form of capital introduced. The principal source of income for a business is the amount generated from the sale of goods or services to customers during an accounting period. Other forms of income include bank interest received and fees or commission earned by a business.
Expenses consists of decreases in assets or increases in liabilities that result in a reduction of capital due to the owner. Examples of expenses include wages paid to employees, repairs and maintenance , insurance and charges for heat, light and power