Accounting Equation

Meaning and Concept of Accounting Equation

The relationship of different assets, capital and liabilities of the business expressed in an equation form is called the accounting equation. In other words, accounting equation is the foundation of double entry accounting. It expresses the relationship between what is owned by an entity.

Accounting equation shows that all assets are either financed by borrowing a loan or paying with the loan of the company's shareholders. Therefore, accounting equation shows the relationship between the elements of accounting. Thus, the accounting equation is: Assets = Liabilities +Owner's Equity

Another method of demonstrating the mathematical relationship involves a simple variation in the equational form. The accounting equation is the statement of equality between the total assets and total claims. There are three basic elements like assets, liabilities and capital.

Mathematically:

Assets = Total claims

OR

Assets = Capital + Liabilities

Principal of Accounting Equation

Accounting measurements reflect the changes in the composition of firm's assets, liabilities and equity subject to the conservation rule reflected in the fundamental equation. The conservation rule is simply that, any net change up or down of a firm's assets must be offset by an equal change to the combination of the liabilities and the equity. If there is any increase in assets, there must be an increase in the total of liabilities and equity. If there is a decrease in asset, there must be a decrease in a total of liabilities and equity.

Assets

Assets are a company's resources that the company owns. Assets can be tangible or intangible. Tangible assets are those assets which have a physical form. Tangible assets include both fixed and current assets. Intangible assets are the opposite of tangible assets. Intangible assets lack physical substances. Examples of intangible assets include patents, copyrights, trademark and franchise licenses.

Liabilities

Liabilities are a company's obligations that the company owes. Liabilities are the existing debts of a company and obligations owned to the third parties. For example, the amount owed to the suppliers for the goods and services received (account payable).

Owner's Equity

Owner'sEquity represents the amount owed to the owners by the company. Algebraically, the amount is calculated by subtracting liabilities from each side of the accounting equation. Owner's equity also represents the net assets of the company.

Net Assets = Owner's Equity = Assets - Liabilities

If a company keeps accurate records, the accounting equation will always be "in balance," meaning both the debit and credit side of account are equal. The balance is maintained because every business transaction affects at least two of a company's accounts. For example, when a company borrows loan from a bank, the company's assets will increase as well as liabilities will also increase by the same amount. Every transaction affects two or more account. So, the accounting system is referred to as double-entry accounting.

Preparation of statement of Accounting Equation

Format of accounting equation are given below:

Effect of transaction upon the accounting equation

The effect of transaction upon the accounting equation can be illustrated by taking a brand – new business as an example

Example 1

Assume that, Mr. Naveed decided to start a "shoe business" of his own to be known as "Naveed Shoe Company ". The new business was started on 1st January, 2005, when Mr. Naveed invested Rs. 500000 in his business. Recall that the business entity is kept separate from its owner.

The business unit has borrowed Rs. 500000 from its owner. This is the first transaction of the business. It brought the double change in the financial position of the business – an asset (cash) increased by Rs. 500000 and a liability (owner`s equity or capital ) increased also by Rs. 500000. In other words, this transaction is consisting of two elements:

1. The receipt of Rs 500000 cash.
2. Supplied by the owner of the business.

The initial accounting equation of the new business then appeared as follows;

Example 2

Mr. Naveen purchased a building for Rs. 200000. This transaction brought two changes – cash assets decreased by Rs. 200000 and the building ( a new asset) increased by Rs. 200000. Now the equation will be ;

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 remain equal.

Example 3

He purchased a furniture for Rs 30000. This transaction brought two changes cash (assets) decreased by Rs 30000 and furniture and (a new asset) increased by Rs 30000. The equation will be

Again, there is no change on the right side of the equation and cash asset is converted into a new asset furniture.

References:

Sharma, Narendra et.al., Principles of Accounting-XI, Bundipuran Prakashan, Kathmandu

Koirala, Yadav Raj et.al., Principles of Accounting-XI, Asmita Books Publication, Kathmandu

Shrestha, Dasharaha et.al., Accountancy-XI, M.K. Prakashan, Kathmandu

Jogindar Goet, Bhesh Raj Banjade, Rajesh Kumar Dutta. (2012). Principal of Accounting, Dreamland Publication, Kalamati, Kathmandu