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 the business and
are called liabilities. The equity of the owner is called capital, or
proprietorship or owner's equity.
The formula know 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 $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 $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 |
Note that assets and
equities increased by equal amounts
Transaction 2:
Purchased furniture on cash $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 | ||
|
| |||||
Note that this
transaction has affected assets side only and no change is made in equities side
of the equation.
Transaction 3:
Purchased merchandise for cash $10,000. This transaction will introduce a new element (merchandise) on the assets side and decrease the cash by $10,000.| Assets | = | Liabilities | + | Proprietorship | ||
| Cash | Furniture | Merchandise | Riaz, Capital | |||
| + 40,000 | + 10,000 | = | ---- | + 50,000 | ||
| -10,000 | -- | + 10,000 | ||||
|
| ||||||
| 30,000 | + 10,000 | = | 50,000 | |||
|
| ||||||
Note that this
transaction has affected assets side only and no change is made in equities side
of the equation.
Transaction 4:
Purchased merchandise on account (on credit) $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 | |
|
| ||||||
Note that this
transaction has affected assets side and liabilities. Both the sides of
equation has increased with the same amount.
Transaction 5:
Sold merchandise for cash $2,000 cost of these merchandise were $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 | |
|
| ||||||
Note that this
transaction has affected assets side and also the proprietorship. Difference
between sales price and cost price is treated as profit and has been added to
capital.
Transaction 6:
Sold merchandise on credit for $4,000 costing $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 | |
|
| |||||||
Note that this
transaction has affected assets side and also the proprietorship. Anew element
"debtors" has been introduced. Difference between sales price and cost price is
treated as profit and has been added to capital.
Transaction 7:
Paid $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 $ 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 $1,000 in cash. This
transaction affected the equation by decrease in a cash asset 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 | $4,000 | Cash | $31,000 |
| Capital | $50,500 | Debtors | 3,000 |
| Merchandise | 10,500 | ||
| Furniture | 10,000 | ||
|
|
| ||
| $54,500 | $54,500 | ||
|
|
|
The presentation of the effects of
transactions in tabular form is only a device which helps beginners to
understand the analysis of different types of transactions. It is not
practically feasible to record the effects of transactions in this form. The
increases and decreases in the various elements are recorded in the journal in a
special technical form.
Read more at http://www.accounting4management.com/accounting_equation.htm#fr5WTUIjfE4ueZt5.99
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