ACCOUNTING

EQUATION
INSTRUCTOR: MUNEER HUSSAIN
LECTURE NO: 3
ACCOUNTING EQUATION

• Accounting equation is the relation between the assets, liabilities and equity of a business.
It states that at any point of time, the value of assets of a business is equal to sum of the
value of its liabilities and its shareholders' equity.
• Assets = Liabilities + Shareholders' Equity
• It is the most basic principle of financial accounting and it underlies the double

entry accounting.
• When entrepreneurs set up a business, the assets of the business (such as office
equipment, inventories, cash, etc.) come from two sources. They are either purchased
using cash invest in the business by the owners (i.e. equity), or they are purchased using
loans obtained from third parties (i.e. liabilities). This is the essence of the accounting
equation. This also holds true for additional investments of capital made or additional
loans obtained.
ASSETS = LIABILITIES + OWNERS EQUITY
(CAPITAL)
• An asset is a resource controlled by a business which is of economic use to the business.
Examples of assets include land, buildings, vehicles, inventory, accounts receivable, cash
and cash equivalents, etc.
• A liability is the obligation of a business towards its creditors i.e. those who provided
loaned cash or loaned assets. Settlement of liabilities result in an outflow of assets.
Common liabilities are accounts payable, salaries payable, taxes payable, etc.
• The equity is the claim of the owners of the business on the business' assets. It represents
the assets leftover after all liabilities have been paid off. Owner's equity contains accounts
such as common stock, retained earnings, etc. The accounting equation can be modified
to define shareholders' equity as follows:
• Shareholders' Equity = Assets − Liabilities
EXAMPLES OF ASSETS

 Cash: Cash includes physical money such as bank notes and coins as well as amount deposited in bank for current
use.
 Accounts Receivable: It includes the money owed to the business by outsiders such as customers and other
businesses. In most cases accounts receivable arise from sales or services provided on credit. There is no interest
on accounts receivable.
 Notes Receivable: Notes receivable include the money owed to business by outsiders for which there is a formal
document for proof of debt. In most cases notes receivable also involve interest.
 Prepaid Insurance: The cost of insurance premium paid in advance.
 Inventory: These are goods and materials held by a business for the purpose of sale or for the production process.
 Supplies: Supplies include items held for use in miscellaneous activities by the business. It may include items
used by business staff (for example: stationary products) and items used in production process (for example nails
used in production of furniture).
 Equipment: Equipment having life more than a year. Examples are Vehicles, Production
Machinery, Computers etc.
 Buildings: Buildings owned by the business. Examples are Office Building, Factory Building,
Warehouse, Garage etc.
 Land: Includes cost of all the land owned by the business. Also includes cost of the land with
building on it.

• Patents, Trade Mark, License: These are assets have no physical existence but have properties of
assets
•The assets cash, accounts receivable, notes receivable, prepaid insurance, inventory and supplies are
categorized as current assets.
•Equipment, buildings, land and patents are categorized as non-current assets.
•Those assets which have no physical existence are called intangible assets.
RULES OF ACCOUNTING

Double Entry Accounting/COMPUNDING ENTRIES

• Double-entry accounting is a method of accounting in which each transaction is recorded such that
the sum of assets is equal to the sum of the company’s liabilities and its shareholders’ equity. In
double entry accounting, each journal entry affects at least two accounts.
• In double-entry accounting, an increase in asset account(s) is compensated by decrease in other
asset account(s) or by increase in liability account(s) or equity account(s) or both, and vice versa.
DEBIT AND CREDIT

• In accounting, debit refers to the left side of an account in the ledger and credit is the right hand side of an
account. In simplest words, these are used to indicate whether a record in a ledger account is an addition to the
account or a subtraction from the account.
• The words debit and credit are also used as verbs describing the action of recording a debit or credit
respectively. Therefore, debiting an account is the action to recording a debit in the account and crediting an
account is the action of recording a credit in the account.
• There is a common misconception that credit means increase and debit means decrease. This is true from the
perspective of an owner of a bank account, but is not true in general sense. The determination of debit and credit
as either increase or decrease is dependent on the ledger account in question and whether the account belongs to
left or right hand side of the accounting equation.
• Simply said, assets increase with debit and decrease with credit whereas liabilities and equity
behave the opposite way. However this gets complicated in case of contra-accounts, which
behave opposite to the normal accounts they relate to. So contra-accounts of assets increase
with credit and decrease with debit whereas the contra-accounts of liabilities and equity behave
the opposite way.
• Revenues and income increase with credits and decrease with debits because they can be taken
as part of equity so revenues follow the same rules as those for equity. Expenses increase with
debit and decrease with credit because in a long stretch, expenses are contra-accounts to equity.
• These rules are summarized below:
• Assets and Expenses
An increase is recorded as debit (left side)
A decrease is recorded as credit (right side)
• Liabilities, Equities and Revenues
A decrease is recorded as debit (left side)
An increase is recorded as credit (right side)
• Contra-accounts
Contra-accounts behave exactly in opposite way to the respective normal accounts.
EXAMPLES

1. The owner brings cash from his personal account into the business:
Cash (an asset) is increased thus debit Cash
Owner capital (an equity) is increased thus credit Owners' Capital
2. Office supplies are purchased on account:
Office Supplies (an asset) is increased thus debit Office Supplies
Accounts Payable (a liability) is increased thus credit Accounts Payable
3. Wages payable are paid:
Wages Payable (a liability) is decreased thus debit Wages Payable
Cash (an asset) is decreased thus credit Cash
4. Revenue is earned but not yet received:
Accounts Receivable (an asset) is increased thus debit Accounts Receivable
Revenue (a revenue) is increased thus credit Revenue
EXAMPLE
ACCOUNTING EQUATION
• In June 20X3, Kumar Sangakara started a tourism business with LKR 15 million in
personal savings. Out of the money he invested, he purchased office building worth LKR
10 million and office equipment worth LKR 3 million. He kept LKR 2 million in cash to
pay routine expenditures and obtained 10 vehicles from Marwan Atapatu Bank (MAB)
for total value of LKR 20 million.
• Let's see how these transactions fit into the accounting equation as at the end of first
month of operations:
SOLUTION

Date Assets Liabilities + Capital

0 cash Building Furniture Car
1 15M 0 15M
2 -13 10M 3M
Bal 2M 10M 3M 0 15M
3 20M 20M
Bal 2M 10M 3M 20M 20M 15M
total 35M = 35M
01. ABC company started business with cash of
200,000 and inventory of 150,000
02. Purchased inventory of 30,000 on cash.
03. purchased furniture of 50,000 on credit from
XYZ trader.
04. sold inventory of 30,000 and received only 50%
cash from ahmed.
05. paid 10,000 to XYZ traders.
10. received 15000 from ahmed.
15. sold inventory to faraz of rs. 15000
20. purchased office supplies of rs. 5000
30. sold inventory of 5000 on cash.
Calculate or prepare accounting equation of above
data.