The Accounting Equation, or "What you MUST understand before going to double entries"
The accounting equation is a very simple concept, all summarized into the following:
Assets = Liabilities + Owner’s Equity
Once this concept is grasped, the recording of accounting entries becomes a breeze. In fact, the equation is THE foundation for accounting, and the recording of debits and credits (accounting entries) is based on it.
To recap:
Assets refer to the resources owned by a business.
Check out Owner's Equity here.
Liabilities are the rights of creditors and debts of the business.
Owner’s Equity refers to the rights of owners, in the form of capital and profits earned (or less losses incurred).
A business transaction, one which has a financial impact, will have an effect on the equation.
For example:
The business owner (say, named Margaret) invested $10,000 cash into her business.
The effect on the equation is:
Cash [Assets] is increased by $10,000.
Capital [Owner’s Equity] is increased by $10,000.
Therefore:
Assets = Liabilities
Up by $10,000 = Up by $10,000
The equation has been maintained; both sides balance out.
The business paid $20,000 to buy a piece of land as a future building site.
In other words, cash is converted into land.
The effect on the equation is:
Land [Assets] is increased by $20,000.
Cash [Assets] is decreased by $20,000.
These transactions balance each other out on the Assets side.
Therefore:
Assets
Up by $20,000 AND
Down by $20,000
Again, balance has been maintained.
The business purchased supplies for $1,500 and agreed to pay the supplier one month from now.
Supplies are a type of asset, specifically called prepaid expenses,which will be used up in the course of business operations.
Since cash is not used to pay for this purchase, something other than cash has to be increased. As this purchase was made on credit, creditors or accounts payable, a liability, will have to increase.
The effect on the accounting equation is:
Supplies [Assets] are increased by $1,500.
Accounts payable [Liabilities] is increased by $1,500.
These transactions balance each other out on the Assets side.
Therefore:
Assets - Up by $1,500
Liabilities - Up by $1,500
Balance has been maintained.
The business received cash of $8,000 for providing services to customers.
A business may supply goods or services to its customers. The earnings from the sale/supply are termed revenue. When revenue is increased, it benefits the business owner; therefore, the Owner's Equity side of the equation is increased.
The effect is:
Cash [Assets] is increased by $8,000.
Revenue [Owner's Equity] is increased by $8,000.
The business paid salaries to its workers using cash of $2,000.
The opposite of revenue is expenses. In the course of earning revenue, the business will have to incur expenses, i.e. to pay for services/supplies. Salaries are paid to workers when they render a service to the business, in the form of work. Expenses represent an eventual outflow from the business owner; therefore, the Owner's Equity side of the equation is decreased.
The effect on the accounting equation is:
Cash [Assets] is decreased by $2,000.
Owner's Equity is increased by $2,000.
The business paid the amount owing to its accounts payable/creditor, of $5,200.
In other words, cash is paid to reduce the outstanding balance due to creditors.
The effect on the accounting equation is:
Cash [Assets] is decreased by $5,200.
Accounts payable [Liabilities]is decreased by $5,200.
The owner of the business withdrew $10,000 from the business for his own use.
This reduces the cash level as well as the capital that was invested into the business, affecting the Owner's Equity.
The effect on the accounting equation is:
Cash [Assets] is decreased by $10,000.
Owner's Equity is decreased by $10,000.
