Every business item is an asset, a liability or capital. Assets are owned, liabilities are owed to outsiders, and capital is the owner’s own investment and claim. Most errors come from mixing up who the claim belongs to.
This lesson builds on the accounting equation through a transaction and belongs to accounting model and transactions.
How do you decide which group an item belongs to?
Ask three short questions in order. First: does the business own it, or will it receive money or something of value from it? If yes, it is an asset.
Second: does the business owe it to someone outside? If yes, it is a liability.
Third: is it the owner’s own money put into the business? If yes, it is capital.
Some assets are cash-like (bank, cash), some are owed to you (receivables) and some are used for years (premises, equipment). Liabilities include supplier debts (payables), loans and overdrafts. Names vary, but the three questions stay the same.
Worked example
Lim’s Laundry Service has these items on 31 March. All amounts are in RM.
| Item | Amount | Group |
|---|---|---|
| Premises | 120,000 | Asset |
| Washing machines | 30,000 | Asset |
| Detergent in store | 2,300 | Asset (inventory) |
| Amounts owed by customers | 4,200 | Asset (receivables) |
| Bank balance | 9,800 | Asset |
| Cash in the till | 1,500 | Asset |
| Bank loan | 40,000 | Liability |
| Amounts owed to suppliers | 6,500 | Liability (payables) |
Step 1, total the assets: 120,000 + 30,000 = 150,000. Add 2,300 to get 152,300. Add 4,200 to get 156,500. Add 9,800 to get 166,300. Add 1,500 to get 167,800.
Step 2, total the liabilities: 40,000 + 6,500 = 46,500.
Step 3, find capital from the equation: Capital = Assets − Liabilities = 167,800 − 46,500 = 121,300.
Step 4, check: 121,300 + 46,500 = 167,800, which equals the assets.
Capital is found last because it is what remains for the owner once outsiders are covered.
The mistake to watch for
A tempting slip is to treat the bank loan as capital, because “the money was put into the business”.
Mistaken working: liabilities are only 6,500, so capital is 167,800 − 6,500 = 161,300.
Check: 161,300 + 6,500 = 167,800. The equation still balances, but the classification is wrong.
Balancing does not prove the groups are right. The loan must be repaid, and the bank is not the owner, so it is a liability of 40,000 and capital is 121,300. A useful test is: “If the business closed, would this person be repaid first as a creditor, or would it be what remains for the owner?”
Check yourself
1. Classify each: (a) rent owed to the landlord, RM900; (b) a customer who owes the business RM1,200; (c) the owner’s own savings paid into the business, RM8,000.
Show answer
(a) Liability (payable): the business owes it. (b) Asset (receivable): the business will receive money. (c) Capital: the owner’s own investment.
2. A business has assets of RM18,000 and liabilities of RM7,500. Find the capital.
Show answer
Capital = 18,000 − 7,500 = RM10,500. Check: 10,500 + 7,500 = 18,000.
3. The business bank account is overdrawn by RM2,000. Is that an asset or a liability?
Show answer
It is a liability, because the business owes the bank that money.
Where this leads next
Next, look at why the owner’s personal spending must be kept out in separating business transactions from personal spending. Try your own classifications in the double-entry and ledger trainer, then use the module practice set.
Some students classify correctly in a list but slip when the wording changes to “loan from a relative” or “owner’s car”. That is the kind of pattern our teachers look for in online one-to-one Accounting tuition.