2019-11-26 12:13:40Accountants and Bookkeepers: Accountants and BookkeepersEnglishAccounting equation is the fundamental equation in accounting that expresses the principle of duality in terms of claims of owners and that...https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2019/11/Accounting-Basics-What-is-an-Accounting-Equation.jpghttps://quickbooks.intuit.com/in/resources/accountants-and-bookkeepers-accountants-and-bookkeepers/accounting-equation/Accounting Basics: What is Accounting Equation?

Accounting Basics: What is Accounting Equation?

9 min read

Every business undertakes transactions in order to conduct its day to day operations. A business transaction is an undertaking that involves exchange of economic consideration between parties involved.

Such an exchange has a two way impact. This is because a transaction involves give and take aspect. Such an aspect leads to recording an exchange in at least two accounts.

For instance, if a business purchases a laptop on cash for Rs. 80,000, the payment of cash pertains to the ‘Give’ effect. Whereas the delivery of the laptop pertains to the ‘Take’ aspect of the transaction.

Additionally, every business transaction is accompanied by an issue of a document that certifies its occurrence. These documents may include a cash memo, invoice, pay-in-slip, cheque, sales bill, salary slips etc.

In case there is no documentary evidence for certain petty expenses, a document known as a voucher or source document is issued.

Now, this dual effect of every business transaction is based on the ‘Dual Aspect Concept’ of accounting. This is one of the fundamental accounting principles. This principle states that every business transaction has a two way effect in accounting. Thus, a business transaction involves a minimum of two accounts when recorded in books of accounts.

This system of recording both the aspects of a transaction is termed as ‘Double Entry System of Accounting’. It is based on the principle of duality which is the very foundation of accounting equation.

What is Accounting Equation?

It is the fundamental equation in accounting that expresses the principle of duality in terms of claims of owners and that of outsiders. Thus, accounting equation is expressed as:

Assets = Liabilities + Capital

The accounting equation states that the assets of a business are always equal to the claims of owners and outsiders. This means that at any point of time, the resources of a business must equate to the claims of the outsiders. These outsiders are the ones who offered funds to finance those resources.

Generally, the resources in business are provided by the owners and outsiders. The claim of the owners is referred to as ‘Capital’. Whereas the claim of outsiders is termed as ‘Liabilities’.

Since each component of this equation pertains to the Balance Sheet, this equation also states the financial position of a business at a particular date. This is to say that every business transaction impacts the balance sheet of a business in some way or the other.

Thus, to understand how this equation affects the balance sheet of a business, let’s understand each of its components:

Assets

Assets are the economic resources that a business entity owns and are of value to the business. These resources are utilized by the business in its operations and are broadly classified into current assets and non – current assets.

Liabilities

These are the obligations or debt that an enterprise has to pay at some time in the future. This means these are the claims that a business entity owes to its owners as well as outsiders.

Further, just like assets, liabilities are broadly classified into current liabilities and long-term liabilities.

Sharholder’s Capital

It refers to the amount invested by the owner of business in the firm. This capital may be brought by the owner in the form of cash or assets. Thus, capital is an obligation and a claim on the assets of the business. Hence, it is shown on the liability side of the balance sheet.

Thus, the assets of a business must always be equal to the liabilities or claims of outsiders at any point of time. This is because of the principle of duality which states that every transaction has a debit entry in one account and credit entry in another account.

To understand this further, let’s have a look at how debit and credit in accounting work.

Debit and Credit in Accounting

Business transactions are to be recorded in at least two accounts in double entry system of accounting. This is to say every amount debited in a transaction must be equal to every amount credited in that transaction.

Thus, the terms debit and credit are used to record every business transaction in accounting. These basically indicate on which side of a particular account a business transaction needs to be recorded.

For example, if it is the Capital Account of the owner, the Cash received is recorded on the Credit side of the Capital account. Whereas, the owner’s claim on the business is recorded on the Debit side of the Cash Account.

Owner’s Capital Account

Particulars (Dr)AmountParticulars (Cr)Amount
By Cash

Cash Account

Particulars (Dr)AmountParticulars (Cr)Amount
To Owner’s Capital

Thus, recording an amount on the left side of the account means debiting the account. Whereas, recording the amount on the right side means crediting the account.

Rules For Debit and Credit

All accounts are divided into five categories in order to record transactions. Following are those categories:

  • Asset
  • Liability
  • Capital
  • Expenses/Losses
  • Income and Gains

Hence, two important rules are followed in order to record the changes in the above categories:

1. Recording Changes in Assets or Expenses or Losses

  • Debit all increase in assets and credit all decrease in assets
  • Debit all increase in expenses or losses and credit all decrease in expenses or losses

2. Record Changes in Liabilities or Capital or Revenues or Gains

  • Credit all increase in liabilities and debit all decrease in liabilities
  • The credit increase in capital and debit decrease in capital
  • Credit all increase in revenue or gain and debit all decrease in revenue or gain

Let us consider an example to show the effect of following transactions of Kapoor Pvt Ltd on its assets and liabilities. Further, let’s understand how both sides of the accounting equation remains the same.

Example

  • Brought Rs. 80,000 as capital in cash and stock worth Rs. 5,000

This entry affects cash and inventory on the asset side and capital on the liability side. This is because there is an increase in cash by Rs. 80,000 and inventory by Rs. 5000 on the asset side of the equation. Thus, the capital increases by Rs. 85,000

  • Purchased machinery for Rs. 30,000. Only, Rs. 1500 was paid in cash and the balance had to be paid at a later date.

This entry impacts cash and machinery on the asset side and liabilities on the other side of the equation. This is because the machinery has increased by Rs. 30,000 and cash decreased with Rs. 1,500. Whereas the liability to pay supplier of machinery has increased by Rs. 28,500.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery
80,000 + 5,000= Nil + 85,000
(1,500) + Nil + 30,000= 28,500
78,500 + 5000 + 30,000= 28,500 + 85,000
Total 1,13,500= 1,13,500
  • Rs. 60,000 was deposited in bank

This entry affects the asset side only. The furniture on the asset side increases by Rs. 10,000 and the bank decreases by the same amount.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank+ Furniture
18,500 + 5,000 + 30,000 + 60,000= 28,500 + 85,000
Nil + Nil + Nil + (10,000) + 10,000
18,500 + 5,000 + 30,000 + 50,000 +10,000= 28,500 + 85,000
Total 1,13,500= 1,13,500
  • Purchased office furniture for Rs. 10,000 and made payment through cheque

This entry affects the asset side only. The furniture on the asset side increases by Rs. 10,000 and the bank decreases by the same amount.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank+ Furniture
18,500 + 5,000 + 30,000 + 60,000= 28,500 + 85,000
Nil + Nil + Nil + (10,000) + 10,000
18,500 + 5,000 + 30,000 + 50,000 +10,000= 28,500 + 85,000
Total 1,13,500= 1,13,500
  • Purchased goods for Rs. 8,000 cash and Rs. 3,500 in credit

This entry affects cash and inventory on the asset side and liability on the other side of the accounting equation. This is because cash has decreased by Rs. 8,000 and inventory has increased by Rs. 11,500 on the asset side of the equation. Also, a liability worth Rs. 3,500 has increased.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank+ Furniture
18,500 + 5,000 + 30,000 + 50,000 +10,000= 28,500 + 85,000
(8,000) + 11,500 + Nil + Nil + Nil= 3,500
10,500 + 16,500 + 30,000 + 50,000 +10,000= 32,000 + 85,000
Total 1,17,000= 1,17,000
  • Purchased goods for Rs. 8,000 cash and Rs. 3,500 in credit

This entry affects cash and inventory on the asset side and liability on the other side of the accounting equation. This is because cash has decreased by Rs. 8,000 and inventory has increased by Rs. 11,500 on the asset side of the equation. Also, a liability worth Rs. 3,500 has increased.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank+ Furniture
18,500 + 5,000 + 30,000 + 50,000 +10,000= 28,500 + 85,000
(8,000) + 11,500 + Nil + Nil + Nil= 3,500
10,500 + 16,500 + 30,000 + 50,000 +10,000= 32,000 + 85,000
Total 1,17,000= 1,17,000
  • Goods amounting to Rs.4,500 were sold for Rs. 6,000 in cash

This entry affects cash and inventory on the asset side and capital on the other side of the accounting equation. This is because cash has increased by Rs. 6,000 and inventory has decreased by Rs. 4,500 on the asset side of the equation. Whereas the capital on the liability side of the equation has increased by Rs. 1,500.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank+ Furniture
10,500 + 16,500 + 30,000 + 50,000 +10,000= 32,000 + 85,000
6,000 + (4,500) + Nil + Nil + Nil= Nil + 1,500
16,500 + 12,000 + 30,000 + 50,000 +10,000= 32,000 + 86,500
Total 1,18,500= 1,18,500
  • Goods costing Rs.8,000 were sold for Rs. 12,500 on credit

This entry affects debtors and inventory on the asset side and capital on the liability side of the accounting equation. This is because debtors have increased by Rs. 12,500 and the inventory has reduced by Rs. 8,000 on the asset side of the equation. Whereas capital on the liability side of the equation has increased by Rs. 4,500.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank+ Furniture + Debtors
16,500 + 12,000 + 30,000 + 50,000 +10,000= 32,000 + 86,500
Nil + (8,000) + Nil + Nil + Nil + 12,500= Nil + 4,500
16,500 + 4,000 + 30,000 + 50,000 +10,000 + 12,500= 32,000 + 91,000
Total 1,23,000= 1,23,000
  • Cheque issued to the supplier of goods worth Rs. 3,500

This entry affects the bank on the asset side and liability on the other side of the accounting equation. This is because bank has decreased by Rs. 3,500 on the asset side and liability has also decreased by Rs. 3,500

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank+ Furniture + Debtors
16,500 + 4,000 + 30,000 + 50,000 +10,000 + 12,500= 32,000 + 91,000
Nil + Nil + Nil + (3,500) + Nil + Nil= (3,500) + Nil
16,500 + 4,000 + 30,000 + 46,500 +10,000 + 12,500= 28,500 + 91,000
Total 1,19,500= 1,19,500
  • Cheque received from customer amounting Rs. 7,500

This entry affects the asset side only. This is because bank on the asset side has increased by Rs. 7,500 and debtors have reduced by the same amount.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank + Furniture + Debtors
16,500 + 4,000 + 30,000 + 46,500 +10,000 + 12,500= 28,500 + 91,000
Nil + Nil + Nil + 7,500 + Nil + (7,500)
16,500 + 4,000 + 30,000 + 54,000 +10,000 + 5,000= 28,500 + 91,000
Total 1,19,500= 1,19,500
  • Owner withdrew cash for personal use Rs. 2,500

This entry affects cash on the asset side of the equation and capital on the liability side of the equation. This is because cash has reduced by Rs. 2,500 on the asset side whereas capital has decreased by Rs. 2,500.

Assets (in Rs)= Liabilities + Capital (in Rs)
Cash + Inventory + Machinery + Bank + Furniture + Debtors
16,500 + 4,000 + 30,000 + 54,000 +10,000 + 5,000= 28,500 + 91,000
(2,500) + Nil + Nil + Nil + Nil + Nil= Nil + (2,500)
14,000 + 4,000 + 30,000 + 54,000 +10,000 + 5,000= 28,500 + 88,500
Total 1,19,500= 1,17,000
Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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