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 business and is called liabilities. The equity of the owner is called capital, or proprietorship or owner's equity.

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

Assets = Equities OR Assets = Liabilities + Proprietorship

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:

Assets - Liabilities = Proprietorship

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 Rs.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 Rs.50,000 and the proprietorship (Riaz's capital) is also increased by the same amount such as:

Assets	=	Liabilities	+	Proprietorship
Cash				Riaz, Capital
+ 50,000	=	----		+ 50,000

Transaction 2:

Purchased furniture on cash Rs.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

Assets		=	Liabilities	+	Proprietorship
Cash	Furniture				Riaz, Capital
+ 50,000		=	----		+ 50,000
- 10,000	+ 10,000
40,000	+ 10,000	=			50,000

Transaction 3:

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

Assets			=	Liabilities	+	Proprietorship
Cash	Furniture	Stock				Riaz, Capital
+ 40,000	+ 10,000		=	----		+ 50,000
-10,000	--	+ 10,000
30,000		+ 10,000	=			50,000

Transaction 4:

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

Assets			=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise		Creditors		Riaz, Capital
+ 30,000	+ 10,000	+ 10,000	=			+ 50,000
		+ 5,000		+ 5,000
30,000	+10,000	+ 15,000	=	+ 5,000		+ 50,000

Transaction 5:

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

Assets			=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise		Creditors		Riaz, Capital
+ 30,000	+ 10,000	+ 15,000	=	+ 5,000		+ 50,000
+ 2,000		- 1,500				+ 500 (Profit)
+ 32,000	+10,000	+ 13,500	=	+ 5,000		+ 50,500

Transaction 6:

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

Assets				=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise	Debtors		Creditors		Riaz, Capital
+ 32,000	+ 10,000	+ 13,500		=	+ 5,000		+ 50,500
		- 3,000	+ 4,000				+ 1,000
32,000	+10,000	+ 10,500	+ 4000	=	+ 5,000		+ 51,500

Transaction 7:

Paid Rs.1,000 to creditors for merchandise purchased.

Assets				=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise	Debtors		Creditors		Riaz, Capital
+ 32,000	+ 10,000	+ 10,500	+ 4,000	=	+ 5,000		+ 51,500
- 1,000					- 1,000
31,000	+10,000	+ 10,500	+ 4000	=	+ 4,000		+ 51,500

Transaction 8:

Received cash from a debtor Rs. 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:

Assets				=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise	Debtors		Creditors		Riaz, Capital
+ 31,000	+ 10,000	+ 10,500	+ 4,000	=	+ 4,000		+ 51,500
+ 1,000			- 1,000
32,000	+10,000	+ 10,500	+ 3000	=	+ 4,000		+ 51,500

Transaction 9:

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

Assets				=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise	Debtors		Creditors		Riaz, Capital
+ 32,000	+ 10,000	+ 10,500	+ 4,000	=	+ 4,000		+ 51,500
- 1,000							- 1,000
31,000	+10,000	+ 10,500	+ 3000	=	+ 4,000		+ 50,500

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

Assets					=	Liabilities	+	Proprietorship
	Cash	+ Furniture	+ Merchandise	+ Debtors		Creditors		+ Riaz, Capital
1	+ 50,000							+50,000
	50,000				=		+	50,000
2	- 10,000	+ 10,000
	40,000	10,000			=		+	50,000
3	- 10,000		+ 10,000
	30,000	10,000	10,000		=		+	50,000
4			+ 5,000			+ 5,000
	30,000	10,000	15,000		=	5,000	+	50,000
5	+ 2,000		- 1,500					+ 500 (Profit)
	32,000	10,000	13,500		=	5,000	+	50,500
6			- 3,000	+ 4,000				+ 1,000 (Profit)
	32,000	10,000	10,500	4,000	=	5,000	+	51,500
7	- 1,000					- 1,000
	31,000	10,000	10,500	4,000	=	4,000	+	51,500
8	+1,000			1,000
	32,000	+ 10,000	+ 10,500	+ 3,000		4,000	+	51,500
9	1,000							1,000
	31,000	10,000	10,500	3,000	=	4,000	+	50,500

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

Cash	+	Furniture	+	Merchandise	+	Debtors	=	Creditors	+	Capital
31,000	+	10,000	+	10,500	+	3,000	=	4,000	+	50,500

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

EQUITIES		ASSETS
Creditors	Rs.4,000	Cash	Rs.31,000
Capital	Rs.50,500	Debtors	3,000
		Merchandise	10,500
		Furniture	10,000
	Rs.54,500		Rs.54,500