How can we use the accounting equation to demonstrate that capital is the net worth of a business entity?
Being a discussion forum between a teacher and his students in a revision class.
Teacher - While in our revision class the other time, some of you mentioned some terms that we can discuss today.
For instance, Sam mentioned the accounting equation. And this was partially discussed by Musa. So now, what is this accounting equation, Alfred?
Alfred - It is an equation that depicts that the value of the resources owned by a business entity and the claims against the resources.
Teacher - Could you please clarify these terms – resources owned and claims against them, James?
James - The resources owned by the entity are the assets of the business entity whereas the claims against them are the liabilities and capital which can be seen as the owner’s equity; hence, in mathematical form, we can write that
Assets = Capital or
Assets = Capital + Liabilities
Teacher - What is the difference between the two equations, Susan?
Susan - The first equation holds true where all the finances of the entity have been capital introduced by the owners, though this may include profit ploughed back into the business overtime. And no debts have been incurred. With this, we say that the entire assets of the business have solely been brought in by the owners.
The second equation only exist where, in addition, there are debts owed to third parties. These are called liabilities. Thus, total assets will have been funded by capital and indebtedness from third parties called creditors
Teacher - Assuming I now write that
Assets – Liabilities = Capital.
What do you have to say about that, Rosemary?
Rosemary - What you have done sir is beyond trying to make capital the subject of the equation. The implication is that when liabilities are removed from total assets, we have what is called net assets. In this case,
Capital = Net Assets or net worth of the business entity
Teacher - With this, I think we can say we are fully prepared for the examination.
Class - We think so, sir
Teacher - While in our revision class the other time, some of you mentioned some terms that we can discuss today.
For instance, Sam mentioned the accounting equation. And this was partially discussed by Musa. So now, what is this accounting equation, Alfred?
Alfred - It is an equation that depicts that the value of the resources owned by a business entity and the claims against the resources.
Teacher - Could you please clarify these terms – resources owned and claims against them, James?
James - The resources owned by the entity are the assets of the business entity whereas the claims against them are the liabilities and capital which can be seen as the owner’s equity; hence, in mathematical form, we can write that
Assets = Capital or
Assets = Capital + Liabilities
Teacher - What is the difference between the two equations, Susan?
Susan - The first equation holds true where all the finances of the entity have been capital introduced by the owners, though this may include profit ploughed back into the business overtime. And no debts have been incurred. With this, we say that the entire assets of the business have solely been brought in by the owners.
The second equation only exist where, in addition, there are debts owed to third parties. These are called liabilities. Thus, total assets will have been funded by capital and indebtedness from third parties called creditors
Teacher - Assuming I now write that
Assets – Liabilities = Capital.
What do you have to say about that, Rosemary?
Rosemary - What you have done sir is beyond trying to make capital the subject of the equation. The implication is that when liabilities are removed from total assets, we have what is called net assets. In this case,
Capital = Net Assets or net worth of the business entity
Teacher - With this, I think we can say we are fully prepared for the examination.
Class - We think so, sir
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