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:
- The receipt of
$500,000 cash.
- 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.
|