The accounting equation is based on the simple idea that a business is worth the sum of resources that belong to the business less what it owes. Whole of accounting revolves around this equation. Mastering this concept will lay a sound base for your accounting education and your career as an accountant. The resources that are in a business are called assets. The part of these resources that are supplied by the owner are called capital (or equity), and those that are supplied by others (hence a liability of the business) are called liabilities. Therefore when the owner of a business introduces resources in to the business we can say that the resources supplied by the owner are equal to the resources in the business, or in other words, Assets = Capital. However, if the the owner of the business has also borrowed money for the business, the business now has a liability. The equation will now change to Assets - Liabilities = Capital. This equation ca be re-arranged to read Assets = Capital + liabilities. Both sides of this equation will always be the same. This is because we are viewing the same information from two different angles. In the first instance we are looking at the equation to ascertain how much in the business belongs to the owner. After re-arranging it we are able to see the break up of the value in business (Assets) represented by different sources. What information do you think can be deduced from this equation at a glance? This equation provides information about the financing of the business, i.e. how much of the resources of the business (assets) are financed by the owner (capital) and how much of these are financed by lenders (liabilities). Assets in a business include land, buildings, plant and machinery, stock of goods/inventory, investments by the business, cash, bank balance, and the money owed by the customers. Liabilities include the amount of money owed by the business to other parties. This amount can be owed for any number of reasons, for instance for buying things or consuming services that the business has not yet paid for. The capital or the equity is comprised of the amount invested in the business by the owner and the profits retained in the business.This accounting equation is presented using the statement called Balance Sheet which shows the position or in other words the snap shot of a business at a point in time.
Example- The accounting equation
Let’s work through an example involving a series of transactions. The transactions are as follows:
Day 1 Joseph commences computer spare part business by the name Joseph Trading and introduces $10,000 cash.
Day 2 Buys stock (computer parts) for $200 paying by cash.
Day 3 Buys motor bike for $300, the money to be paid later.
Day 4 Sells all the goods bought on Day 2 for $200, money to be received later.
Day 5 Deposits $100 of the cash into a bank account opened in the name of the business.
Day 6 Pays $300 in cash in settlement of the amount owed for the motor bike.
Day 7 The debtor makes a part payment of $100 by cheque
Using the accounting equation, we will draw up a balance sheet as at the end of each day.
Day 1: Joseph commences business introducing $10,000 cash
The dual effect of this transaction is:
1. Joseph trading has $10,000 of cash
2. Joseph trading owes the owner $10 ,000 - this is capital
Day 2: Buys stock (computer parts) for $200 cash.
The dual effect of this transaction is:
1. Joseph trading has $200 worth of stock
2. Joseph trading has spent $200 cash
Day 3: Buys motor bike for $300, money to be paid later.
The dual effect of this transaction is:
1. Joseph trading has a motor bike worth $300
2. Joseph trading owes $300 to the supplier which is a liability of the business, hence a creditor is created. A creditor is someone to whom the business owes money
Day 4: Sells all the goods bought on Day 2 for $200, money to be received later
The dual effect of this transaction is:
1. Joseph trading does not own the stock worth $200 anymore.
2. Joseph trading has acquired a new asset, debtor worth $200. A debtor is someone who owes money.
Day 5: Withdraws $100 of the cash from the cash box and deposits it into a bank account opened in the name of the business.
The dual effect of this transaction is:
1. Cash balance of Joseph trading is down by $100.
2. Joseph trading has acquired a new asset, cash at bank.
Day 6: Pays $300 in cash in settlement of the amount owed for the motor bike
The dual effect of this transaction is:
1. Cash balance of Joseph trading is down by $300.
2. The liability owed by the business to the creditor has been paid off.
Day 7: The debtor makes a part payment of $100 by cheque
The dual effect of this transaction is:
1. The debtor balance reduces by $100.
2. The bank balance increases by $100.
The items on the balance sheet are presented in the order of liquidity, with the least liquid item on the top. The re-arranged Balance Sheet will look like this:
The Balance Sheet will now be categorized into Fixed Assets, Current assets, and current liabilities. Fixed assets are those assets that have been bought for use in the business and not for the purpose of reselling in the normal course of business. Current assets consist of debtors, cash, stock of goods and any other item that has a short life. Current liabilities include payments that are falling due within one year for example stock of goods bought on credit. Since all the liabilities have been paid off, you will not find liabilities on the bBlance Sheet. The categorized Balance Sheet will look as follows:
