Section A: Key terms and recall
Define the term 'assets' and provide two examples. [2 marks]
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Assets are resources owned or controlled by a business that are expected to provide future economic benefits. Examples include cash, inventory, and equipment. [2 marks]
Define the term 'liabilities' and provide two examples. [2 marks]
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Liabilities are present obligations of a business to transfer an economic resource as a result of past events. Examples include loans and accounts payable. [2 marks]
Define the term 'owner's equity' and provide a formula to calculate it. [2 marks]
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Owner's equity is the residual interest in the assets of a business after deducting liabilities. It can be calculated using the formula: Owner's Equity = Assets - Liabilities. [2 marks]
Write down the accounting equation. [1 mark]
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The accounting equation is: Assets = Liabilities + Owner's Equity. [1 mark]
Explain the relationship between assets, liabilities, and owner's equity as shown in the accounting equation. [2 marks]
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The accounting equation shows that the total value of a business's assets is equal to the sum of its liabilities and owner's equity. This relationship must always hold true, as any change in one component must be balanced by a change in another. [2 marks]
Section B: Applying your knowledge
A business has assets worth £50,000 and liabilities worth £20,000. Calculate the owner's equity. [2 marks]
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Owner's Equity = Assets - Liabilities = £50,000 - £20,000 = £30,000. [2 marks]
A sole trader starts a business by investing £25,000 in cash and £10,000 worth of equipment. Calculate the total assets and owner's equity of the business. [2 marks]
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Total Assets = Cash + Equipment = £25,000 + £10,000 = £35,000. Owner's Equity = Total Assets = £35,000 (as there are no liabilities at the start). [2 marks]
A business purchases inventory worth £3,000 on credit. Explain how this transaction affects the accounting equation. [2 marks]
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This transaction increases both assets (inventory) and liabilities (accounts payable) by £3,000, keeping the accounting equation balanced. [2 marks]
A business pays off a £5,000 loan. Explain how this transaction affects the accounting equation. [2 marks]
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This transaction decreases both assets (cash) and liabilities (loan) by £5,000, keeping the accounting equation balanced. [2 marks]
A business sells goods for £1,000 cash. Explain how this transaction affects the accounting equation. [2 marks]
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This transaction increases cash (an asset) by £1,000 and increases owner's equity (retained earnings) by £1,000, keeping the accounting equation balanced. [2 marks]
Section C: Explain and analyse
Explain how the accounting equation helps in understanding the financial position of a business. Provide two examples of decisions that a business owner might make based on the information provided by the accounting equation. [4 marks]
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The accounting equation helps in understanding the financial position of a business by showing the relationship between its assets, liabilities, and owner's equity. This information is crucial for making informed business decisions. For example, a business owner might use the accounting equation to: 1. Determine the amount of capital available for investment in new projects by looking at the owner's equity. 2. Assess the business's ability to meet its short-term obligations by comparing current assets to current liabilities. [4 marks]
Analyse the impact of the following transactions on the accounting equation of a business:
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1. The business owner invests an additional £10,000 in cash: Assets (cash) increase by £10,000, and owner's equity increases by £10,000. 2. The business takes out a £15,000 loan from a bank: Assets (cash) increase by £15,000, and liabilities (loan) increase by £15,000. 3. The business purchases equipment worth £8,000 using cash: Assets (equipment) increase by £8,000, and assets (cash) decrease by £8,000. 4. The business makes a profit of £5,000 during the accounting period: Owner's equity (retained earnings) increases by £5,000. [6 marks]
Calculations
| Description | Amount (£) |
|---|---|
| Initial cash investment | 20,000 |
| Initial inventory investment | 10,000 |
| Credit purchase of equipment | 5,000 |
| Credit sale of goods | 3,000 |
| Cash received from customer | 3,000 |
| Cash payment to supplier | 2,000 |
Using the table above, calculate the total assets, liabilities, and owner's equity of the business after all these transactions. [6 marks]
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Total Assets = Cash + Inventory + Equipment = £21,000 + £10,000 + £5,000 = £36,000 Total Liabilities = Accounts Payable = £3,000 (credit purchase of equipment) - £2,000 (cash payment to supplier) = £1,000 Owner's Equity = Total Assets - Total Liabilities = £36,000 - £1,000 = £35,000 [6 marks]
Challenge
A business has the following financial information:
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Withdrawing £10,000 from the business decreases assets (cash) by £10,000 and decreases owner's equity (retained earnings) by £10,000. The new values are: - Assets: £80,000 - £10,000 = £70,000 - Liabilities: £30,000 (unchanged) - Owner's Equity: £50,000 - £10,000 = £40,000 [4 marks]