Accounting Equation:

Learning Objective:

1. Define and explain accounting equation.

2. Give an example of accounting equation.

Definition and Explanation of Accounting Equation:

Dual aspect may be stated as "for every debit, there is a credit." Every transaction should have twofold effect to the extent of the same amount. This concept has resulted in accounting equation which states that at any point of time the assets of any entity must be equal (in monetary terms) to the total of equities. In other words, for every business enterprise, the sum of the rights to the properties is equal to the sum of the properties owned. The properties of the business are called "assets". The rights to the properties are called "equities". Equities may be sub-divided into two principle types: The rights of the creditors and the rights of the owners. The equity of the creditors represents debts of the the business and are called liabilities. The equity of the owner is called capital, or proprietorship or owner's equity.

The formula know as the accounting equation, thus arrived at is as follows:

Another method of demonstrating the mathematical relationship involves a simple variation in the form of equation. Again it begins with the position that every business owns or has interest in certain assets. It also owes certain amounts to its creditors. The difference between what it owns and what it owes represents the owner's capital or proprietorship. Thus the original equation is changed into:

Effects of Transactions on the Accounting Equation:

Each and every business transaction affects the elements of accounting equation. The effect is shown by the use of (+) or (-) placed against the elements affected. Note particularly that the equation remains in balance after each transaction. The accounting equation can be understood with the help of the following example:

Example:

Transaction 1:

Mr. Riaz commences his business with cash $50,000. This is an example of investment of asset in the business by the owner. The effect of this transaction on the accounting equation is that cash asset is increased by $50,000 and the proprietorship (Riaz's capital) is also increased by the same amount such as:

Note that assets and equities increased by equal amounts

Transaction 2:

Purchased furniture on cash $10,000. This transaction effected accounting equation as the increase in one new asset furniture and decreases in assets cash with the same amount. Thus

Note that this transaction has affected assets side only and no change is made in equities side of the equation.

Transaction 3:

Purchased merchandise for cash $10,000. This transaction will introduce a new element (merchandise) on the assets side and decrease the cash by $10,000.

Note that this transaction has affected assets side only and no change is made in equities side of the equation.

Transaction 4:

Purchased merchandise on account (on credit) $5,000.

Note that this transaction has affected assets side  and liabilities. Both the sides of equation has increased with the same amount.

Transaction 5:

Sold merchandise for cash $2,000 cost of these merchandise were $1,500.

Note that this transaction has affected assets side  and also the proprietorship. Difference between sales price and cost price is treated as profit and has been added to capital.

Transaction 6:

Sold merchandise on credit for $4,000 costing $3,000.

Note that this transaction has affected assets side  and also the proprietorship. Anew element "debtors" has been introduced. Difference between sales price and cost price is treated as profit and has been added to capital.

Transaction 7:

Paid $1,000 to creditors for merchandise purchased.

Transaction 8:

Received cash from a debtor $ 1,000 whom a sale on credit was made earlier. This is an example of collection from debtors. This transaction is an exchange of one asset for another. the effect is on one side of the equation, i.e., asset side. Thus:

Transaction 9:

Paid salaries $1,000 in cash. This transaction affected the equation by decrease in a cash asset and decrease in proprietorship (i.e., capital). Thus:

Effects of all the transactions explained above are presented in the following table:

The elements of the equation of Mr. Riaz that is,

This may also be stated in vertical form as shown below:

The presentation of the effects of transactions in tabular form is only a device which helps beginners to understand the analysis of different types of transactions. It is not practically feasible to record the effects of transactions in this form. The increases and decreases in the various elements are recorded in the journal in a special technical form.

You may also be interested in other relevant articles:

1. Accounting Concepts

2. Accounting Conventions

3. Accounting Equation

Back to Home Page | Accounting Principles and Accounting Equation