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Accounting Equation:

Definition and Explanation:

The three basic elements of accounting are assets, liabilities and owners' equity (capital). The assets represent the things of value that a business owns. The liabilities are the claims of the creditors against those assets. The owner's equity (capital) is the claim of the owner against those assets. Whatever is not claimed by the creditors belongs to the owner. As a result, the total claims against the assets are always equal to the total assets. This equality between the assets and the liabilities and the owner's equity is expressed by the "accounting equation".

Assets    =    Liabilities    +    Owner's Equity

The two sides of the accounting equation must always be equal because the rights, to all the assets of a business are owned by someone. The creditors have a claim against the assets of a business until the liabilities have been paid. The owner has a claim against the remaining assets of the business. If no liabilities exist, then the owners' equity will equal to the total assets.

A clear understanding of the accounting equation is essential, because most of accounting systems based on it. The equation actually identifies the claims (or rights) against the assets held by a business. The two sides represent different versions of the same thing. The left side of the equation, assets, consists of the "resources" (properties) held by the business; the right side of the equation, equities (creditor's claim and owner's claim against the assets) consists of the "sources".

Resources: what they are  = Sources: who supplied them
Assets  = Claims against assets

"The expression of the equality of an entity's assets with the claims against them is referred to as the accounting equation."

It should be remembered that the two sides of the equation are always equal because these two sides are merely two views of the same business resources. The assets side shows us "what resources" the business owns, the other side (liabilities and owner's equity) tells us "who supplied these resources" to the business and how much each group supplied.

Effect of Business Transactions:

Recall that every business transaction brings about a double change in the financial position of the business. The financial position of a business is represented by the accounting equation:

Assets    =    Liabilities    +    Owner's Equity

Regardless of whether a business grows or contracts this equality between the assets and the claims against the assets is always maintained. Any increase in the amount of total assets is necessarily accompanied by an equal increase on the other side of the equation, that is, by an increase in either the liabilities or the owner's equity. Any decrease in the amount of total assets is necessarily accompanied by an equal decrease in liabilities or owner's equity. Any expense incurred will decrease the owner's equity on one side and decrease cash on the other side of the equation. Any revenue earned will increase the owner's equity on one side and increase assets on the other side.

The effect of transactions upon the accounting equation can best be illustrated by taking a brand-new business as an example:

Example:

Assume that Mr. Naveed decided to start a "shoes business" of his own, to be known as Naveed Shoes Company". The new business was started on 1st January, 2005, when Mr. Naveed invested $5,00,000 in his business. Recall that the business entity is kept separate from its owner.

The business unit has borrowed $5,00,000 from its owner. This is a first transaction of the business. It brought a double change in the financial position of the business — an asset (cash) increased by $5,00,000 and a liability (owner's equity or capital) increased also by $5,00,000. In other words, this transaction is consisting of two elements:

  1. The receipt of $500,000 cash.
  2. Supplied by the owner of the business.

The initial accounting equation of the new business then appeared as follows:

Assets = Liabilities + Owner's equity

 
Cash =     Capital
$500,000 = Nil + $500.000

 

Transaction No. 2:

Mr. Naveed purchased a building for $2,00,000. This transaction brought two changes—cash (asset) decreased by $2,00,000 and Building (a new asset) increased by $2,00,000. Now the equation will be;

Assets = Liabilities + Owner's equity

 
Cash + Building =     Capital
$300,000 + 200.000 = Nil + $500.000

 

It may be noted that there is no change on the right side of the equation. Simply one asset (cash) has been converted into another asset (Building). The two sides of the equation remains equal.

Transaction No. 3:

He purchased furniture for $30,000. This transaction brought two changes—cash (asset) decreased by $30,000 and furniture (a new asset) increased by $30,000. The equation will be;

Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture =     Capital
$270,000 + 200.000  + 30.000 = Nil + $500.000

 

Again there is no change on the right side of the equation and cash (asset) is converted into a new asset, furniture.

Transaction No. 4:

He purchased goods (shoes) for $1,50,000 to stock up the business. This transaction brought two changes - cash (asset) decreased by $1,50,000 and goods (stock) increased by $1,50,000. Again, there is no change on the right side of the equation. The equation will be:

Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture  + Goods =     Capital
$120000 + 200000 + 30000 + 150000 = Nil + $500.000

 

Transaction No. 5:

He sold goods costing $60,000 for $80,000 for cash. This transaction has brought three changes (a) cash (asset) increased by $80,000; (b) stock of goods decreased by $60,000; (c) the difference between sale price of goods (80,000) and cost price of goods (60,000) is profit of $20,000, it would increase the owner's equity by $20,000. The equation will be:

Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture + Goods =     Capital
$120000 + 200000 + 30000 + 150000 =     500,000

+80000

        - 60000   Nil + 20,000

 
200000 + 200000 + 30000 + 90000 = Nil + 520000

 

Transaction No. 6:

He purchased goods (shoes ) for $ 30,000 on credit basis. This transaction has brought two changes Goods (stack) increased by $30,000 and a liability (creditor) is created, as goods have been purchased on credit basis: The equation will be as follows:

Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture + Goods   Creditors + Capital
$200000 + 200000 + 30000 + 90000 = Nil + 520,000
          + 30000   30000    

 
$200000 + $200000 + 30000 + 120000 = 30000 + 520,000

 

Transaction No. 7:

He sold goods costing $50,000 for $70,000 on credit basis. The result of this transaction is (a) Stock of goods is reduced by $50,000; (b) A new asset (debtor) is increased by $70,000, as goods have been sold on credit basis; (c) The owner's equity is increased by $20,000 (the profit The equation will be:

Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture + Goods + Debtors = Creditors   + Capital
200000 + 200000 + 30000 - 120000 + Nil = 30000 + 520,000
- 50000 + 70000 20000


200000 + 200000 + 30000 + 70000 + 70000 = 30000 + 540000


Transactions No. 8:

Creditor was paid $30,000. The result of this transaction is - a liability (creditor) is decreased by $30,000 and cash (asset) is also decreased by $30,000. Now the equation is:
 
Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture + Goods + Debtors = Creditors   + Capital
200000 + 200000 + 30000 + 70000 + 70000 = 30000 + 540000

- 30000

- 30000


170000 + 200000 + 30000 + 70000 + 70000 = Nil + 540000


Transaction No. 9:

Cash received from the debtor $40,000. The result of this transaction is - cash (asset) increased by $40,000 and debtor (asset) decreased by $40,000. The equation is:
 
Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture + Goods + Debtors = Creditors   + Capital
170000 + 200000 + 30000 + 70000 + 70000 = Nil + 540,000

+ 40000

- 40000


210000 + 200000 + 30000 + 70000 + 30000 = Nil + 540000


Transaction No. 10:

Goods costing $25,000 were lost by fire. The result of this transaction is - stock of goods is reduced by $25,000 and owner's equity is also decreased by $25,000 (as loss will be born by the owner). The equation is:
 
Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture + Goods + Debtors = Creditors   + Capital
210000 + 200000 + 30000 + 70000 + 30000 = Nil + 540,000
- 25000 - 25000


210000 + 200000 + 30000 + 45000 + 30000 = Nil + 515000


Transaction No. 11:

He paid salaries and telephone bill $7,000. The result of this transaction is - cash (asset) is decreased by $7,000 and owner's equity is also decreased by 7,000 (the expenses reduced the owner's equity). The equation is:
 
Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture + Goods + Debtors = Creditors   + Capital
210000 + 200000 + 30000 + 45000 + 30000 = Nil + 515000

- 7000

- 7000


203000 + 200000 + 30000 + 45000 + 30000 = Nil + 508000


Transaction No. 12:

He borrowed money from a bank (as bank loan) $50,000. The result of this transaction is - cash (asset) is increased by $50,000 and a new liability (bank loan) is created (increased) by $50,000. The accounting equation is:
 
Assets = Liabilities + Owner's equity

 
Cash + Building + Furniture + Goods + Debtors = Creditors     Bank Loan + Capital
203000 + 200000 + 30000 + 45000 + 30000 = Nil   0 + 508000

+ 50000

+ 50000


253000 + 200000 + 30000 + 45000 + 30000 = Nil 50000 + 508000


 

Resources = Sources
(Assets) = (Equities)
558000 = 558000

It may be noted that equality of the two sides was maintained throughout the recording of the transactions.

 

More study material from this topic:

Definition and explanation of a business transaction
Features of transaction
Classification of transactions
Cash and credit transactions
Accounting equation with an example
Questions and answers

 

 
 

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Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
----------------------------------------------------------------------------
  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
----------------------------------------------------------------------------
  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
----------------------------------------------------------------------------
  Standard Costing and Variance Analysis
----------------------------------------------------------------------------
  Balanced Scorecard
----------------------------------------------------------------------------
  Capital Investment Analysis/Capital Budgeting
 
 

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