Accounting equation - income increased capital?

Danielle Milton

Hay,

I'm learning the Accounting equation and I thought I had it until I read that increase in income = increase in capital. I'm not sure how that works. My understanding was capital was what the owner put into the business to start the company.

So by that logic it can only go up if the owner invests more into the business and go down with re-payments or drawings. How does the company making profit by selling goods/services increase the capital.

For example, I give Joe £100 (capital) and he uses that £100 (liabilities) to buy ingredients (a type of asset) and then sells the cakes and makes £200 (asset) from the sale of cakes. My capital is still £100. I didn't give him anymore capital and the fact he made assets from the sale of cakes does not change the fact I originally only gave £100.

I understand that if the company makes an asset i.e. it's cash increases because they have sold goods and services then either liability or capital has to change to keep the equation balanced. I'm just not able to get my head around why.

Danielle

coojee

Danielle Milton wrote: »

Hay,

I'm learning the Accounting equation and I thought I had it until I read that increase in income = increase in capital. I'm not sure how that works. My understanding was capital was what the owner put into the business to start the company.

So by that logic it can only go up if the owner invests more into the business and go down with re-payments or drawings. How does the company making profit by selling goods/services increase the capital.

For example, I give Joe £100 (capital) and he uses that £100 (liabilities) to buy ingredients (a type of asset) and then sells the cakes and makes £200 (asset) from the sale of cakes. My capital is still £100. I didn't give him anymore capital and the fact he made assets from the sale of cakes does not change the fact I originally only gave £100.

I understand that if the company makes an asset i.e. it's cash increases because they have sold goods and services then either liability or capital has to change to keep the equation balanced. I'm just not able to get my head around why.

Danielle

In this context, capital means equity or how the business is financed. The accounting equation is effectively the balance sheet, in the top half you have assets less liabilities which gives total net assets. In the bottom half you have "Financed by", this includes capital, shares and retained profits. When a profit is made it is transferred to the bottom half of the balance sheet thereby increasing the "financed by" section. And when a loss is made it reduces the "financed by" section.

In your example, the entries would be:

DR Bank £100
CR Loan from you £100

DR Purchases £100
CR Bank £100

DR Bank £200
CR Sales £200

The net effect of these transactions is:

P and L account:
Sales £200
Purchases £100
Net profit £100

Balance Sheet:

Bank Account £200 (asset)
Loan Account £100 (liability)
Net assets £100

Financed by:
Retained profit £100 (capital)

So the accounting equation balances: Asset £200 less liability £100 equals capital £100

omega man

I do not agree with the above. The assets are £200 less liabilities 0 = £200 less capital £200.
The financed by is capital £100 plus retained profits of £100 = £200

Nps

It depends on if the original £100 was a loan (so a liability to be repaid) or an investment of capital (therefore equity). The OP mentions both so it is unclear, but in the absence of further info, I would show it as a liability as it doesn't belong to the business so is not equity, hence I agree with the first response.

CeeJaySix

It's a technical issue that gives the same result. If Joe put in the money it would (usually) be treated as a director's loan (capital); as the OP mentions 'I give Joe' then it could be a loan (exactly the same as a bank loan) and included as a liability.

In either case the point is that it is the retained profit that makes the equation balance - the money the business has made in the year is retained for use later. Another option especially common in LLPs would be that the profit for the year is posted directly to the DLA before finalising the financial statements (so no profit is made) - so now the 'capital' element is all DLA (if the original £100 is posted to DLA rather than as a loan).

coojee

Nps1976 wrote: »

It depends on if the original £100 was a loan (so a liability to be repaid) or an investment of capital (therefore equity). The OP mentions both so it is unclear, but in the absence of further info, I would show it as a liability as it doesn't belong to the business so is not equity, hence I agree with the first response.

This was my thinking, the OP says I give Joe the money so it's a loan to Joe. If Joe put's his own money then it's Capital. I was going to mention this in my first post but I decided that it would have been stating the obvious so I took it out.

Danielle Milton

In the example it was meant as Capital not a lone (unless you count drawnings as re-paying). I spoke to someone at work and they explained that the definition of Capital I was working with didn't fit the equation. They mean capital the way post two meant it. It makes a lot more sense now. Thank you for posting those answers.