26 dec 2018

Contents
Accounting equation..................................................................................................................................2
DEFINITION AND EXPLANATION .............................................................................................................3
EXAMPLE.................................................................................................................................................3
SOLUTION............................................................................................................................................4
ACCOUNTING EQUATION AND BUSINESS  TRANSACTIONS..................................................................4
EXAMPLE :..............................................................................................................................................4
Solution...................................................................................................................................................5
THE ACCOUNTING EQUATION IN ACTION..............................................................................................8
ACCOUNTING EQUATION

Accounting equation describes that the total value of assets of a business is always equal to its
liabilities plus owner’s equity. This equation is the foundation of modern double entry system of
accounting being used by small proprietors to large multinational corporations. Other names
used for accounting equation are balance sheet equation and fundamental or basic accounting
equation.

Assets = Liabilities + Owner’s Equity

ASSETS

Items owned by a business that will provide future benefits.

MUST BE “OWNED” NOT RENTED

Items owned by a business that will provide future benefits.

BUT DOESN’T HAVE TO BE PAID OFF, COULD STILL BE

MAKING PAYMENTS ON IT

Examples

Cash, Merchandise, Furniture ,Fixtures, Machinery , Buildings , Land , Accounts Receivable

LIABILITIES

A probable future outflow of assets as a result of a past transaction or event.

IN OTHER WORDS, DEBTS OR OBLIGATIONS OF THE BUSINESS THAT CAN BE

PAID WITH CASH, GOODS, OR SERVICES.

Examples: • Accounts Payable • Notes Payable

OWNER’S EQUITY

Amount by which the business assets exceed the business liabilities. Also called:

NET WORTH OR CAPITAL

DEFINITION AND EXPLANATION
We know that every business owns some properties known as assets. The claims to the assets
owned by a business entity are primarily divided into two types – the claims of creditors and the
claims of owner. In accounting, the claims of creditors are referred to as liabilities and the claims
of owner are referred to as owner’s equity.

Accounting equation is simply an expression of the relationship among assets, liabilities and
owner’s equity in a business. The general form of this equation is given below:

Assets = Liabilities + Owner’s Equity

Notice that the left hand side (also known as assets side) of the equation shows the resources
owned by the business and the right hand side (also known as equity side) shows the sources of
funds used to acquire the resources. All assets owned by a business are acquired with the funds
supplied either by creditors or by owner. In other words, we can say that the value of assets in a
business is always equal to the sum of the value of liabilities and owner’s equity. The total dollar
amounts of two sides of accounting equation are always equal because they represent two
different views of the same thing.

In accounting equation, the liabilities are normally placed before owner’s equity because
the rights of creditors are always given a priority over the rights of owners. Because of this
preference, the liabilities are sometime transposed to the left side which results in the following
form of accounting equation:

Assets – Liabilities =  Owner’s Equity

If dollar amounts of any two of the three elements are known, we can solve the equation to find
the third one. For example, if a business has total assets amounting to $200,000 and total
liabilities amounting to $60,000, the owners equity must be equal to $140,000 as computed
below:

Assets – Liabilities =  Owner’s Equity

$200,000 – $60,000 = $140,000

EXAMPLE

Using the concept of accounting equation, compute missing figures from the following:

1. Assets = $50,000, Liabilities = $20,000, Owner’s equity = ?

2. Assets = ?, Liabilities = $10,000, Owner’s equity = $15,000
3. Assets = $60,000, Liabilities = ?, Owner’s equity = $40,000
 4. Assets = ?, Liabilities + Owner’s equity = $150,000
SOLUTION
1. Owner’s equity = Assets – Liabilities
= $50,000 – $20,000
= $30,000
2. Assets = Liabilities + Owner’s equity
= $10,000 + $15,000
= $$25,000
3. Liabilities = Assets – Owner’s equity
= $60,000 – $40,000
= $20,000
4. The basic accounting equation is: Assets = Liabilities + Owner’s equity. If liabilities plus
owner’s equity is equal to $150,000, the assets must also be equal to $150,000.

ACCOUNTING EQUATION AND BUSINESS  TRANSACTIONS

Every business transaction impacts accounting equation in terms of dollar amounts but the
equation as a whole always remains in balance. Any increase in one side is balanced either by a
corresponding decrease in the same side or by a corresponding increase in the other side and any
decrease is balanced either by a corresponding increase in the same side or by a corresponding
decrease in the other side. For better explanation, consider the impact of twelve transactions
included in the following example:

EXAMPLE :

Mr. John started a T-shirts business to be known as “John T-shirts”. He performed following
transactions during the first month of operations:

1. Mr. John invested a capital of $15,000 into his business.

2. He purchased a building for $5,000 cash for business use.
3. He purchased furniture for $1,500 cash for business use.
4. He purchased T-shirts from a manufacturer for $3,000 cash.
5. He sold T- shirts for $1,000 cash, the cost of those T-shirts were $700.
6. He purchased T-shirts for $2,000 on credit.
7. He sold T-shirts for $800 on credit, the cost of those shirts were $550.
8. He paid $1,000 cash to his payables.
9. He collected $800 cash from his receivables.
10. The shirts costing $100 were stolen by someone.
11. Mr. John paid $150 cash for telephone bill.
12. He borrowed money amounting to $5,000 from City Bank for business purpose.

Required: Explain how each of the above transactions impacts the accounting equation of John
T-shirts.
Solution

Transaction 1: The investment of capital by John is the first transaction of John T-shirts which
creates very initial accounting equation of the business.  At this point, the cash is the only asset
of business and owner has the sole claim to this asset. Therefore, the equation would look like
the following:

Equation element(s) impacted as a result of transaction 1: “Assets” & “Owner’s equity”.

Transaction 2: The second transaction is the purchase of building which brings two changes.
First, it reduces cash by $5,000 and second, the building valuing $5,000 comes into the business.
In other words cash amounting to $5,000 is converted into building. The impact of this
transaction on accounting equation is shown below:

Equation element(s) impacted as a result of transaction 2: “Assets”

Transaction 3: The impact of this transaction is similar to that of transaction number 2. Cash
goes out of and furniture comes in to the business. On asset side, The reduction of $1,500 in cash
is balanced by the addition of furniture with a value of $1,500.

Equation element(s) impacted as a result of transaction 3: “Assets”

Transaction 4: The impact of this transaction is similar to transactions 2 and 3. One asset (i.e,
cash) goes out and another asset (i.e, inventory) comes in. The cash would decrease by $3,000
and at the same time the inventory valuing $3,000 would be recorded on the asset side.

Equation element(s) impacted as a result of transaction 4: “Assets”

Transaction 5: In this transaction, shirts costing $700 are sold for $1,000 cash. It increases cash
by $1,000 and reduces inventory by $700. The difference of $300 is the profit of the business
that would be added to the capital. The whole impact of this transaction on accounting equation
is shown below:

Equation element(s) impacted as a result of transaction 5: “Assets” & “Owner’s equity”

Transaction 6: In this transaction, T-shirts costing $2,000 are purchased on credit. It increases
inventory on asset side and creates a liability of $2,000 known as accounts payable (abbreviated
as A/C P.A) on the equity side of the equation. Since it is a credit transaction, it has no impact on
cash.

Equation element(s) impacted as a result of transaction 6: “Assets” & “liabilities”

Transaction 7: In this transaction, the business sells T-shirts costing $550 for $800 on credit. It
reduces inventory by $550 and creates a new asset known as accounts receivable (abbreviated as
A/C R.A) valuing $800. The difference of $250 is profit of the business and would be added to
capital under the head owner’s equity.
Equation element(s) impacted as a result of transaction 7: “Assets” & “Owner’s equity”

Transaction 8: In this transaction, business pays cash amounting to $1,000 for a previous credit
purchase. It will reduce cash and accounts payable liability both with $1,000.

Equation element(s) impacted as a result of transaction 8: “Assets” & “Liabilities”

Transaction 9: In this transaction, the business collects cash amounting to $800 for a previous
credit sale. On asset side, it increases cash by $800 and reduces accounts receivable by the same
amount.

Equation element(s) impacted as a result of transaction 9: “Assets”

Transaction 10: The loss of shirts by theft reduces inventory on asset side and capital on equity
side both by $100. All expenses and losses reduce owner’s equity or capital.

Equation element(s) impacted as a result of transaction 10: “Assets” & “Owner’s equity”

Transaction 11: The payment of telephone and electricity bills are business expenses that
reduce cash on asset side and capital on equity side both by $150.
Equation element(s) impacted as a result of transaction 11: “Assets” & “Owner’s equity”

Transaction 12: The loan is a liability because the John T-shirts will have to repay it to the City
Bank. This transaction increases cash by $5,000 on asset side and creates a “bank loan” liability
of $5,000 on equity side.

Equation element(s) impacted as a result of transaction 12: “Assets” & “Liabilities”

In above example, we have observed the impact of twelve different transactions on accounting
equation.

THE ACCOUNTING EQUATION IN ACTION

An example of how the three values relate: If a business wishes to purchase a new asset, such as
computer equipment that costs £300, the purchase can be made using cash (an asset), with owner
equity (earnings or funds) or with a liability (such as borrowed money). If a liability is used for
the purchase, the £300 can then be paid off using assets or with the use of a new liability, such as
a bank loan.
REFERENCES

https://www.accountingformanagement.org/accounting-equation/

https://debitoor.com/dictionary/accounting-equation

https://courses.lumenlearning.com/suny-finaccounting/chapter/the-basic-accounting-equation/

http://www.mccc.edu/~horowitk/documents/Chapter02_003.pdf