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Accounting Equation

Accounting Equation

The business entity concept is a very important concept in accounting.  It is from this concept that the accounting equation originates.  The business entity concept regards the business as separate and distinct from the owner and other parties. 

So when A. Jack, an owner of a business, commences business with $30,000 cash capital, he has actually created a new entity quite separate from himself.  The business as a new entity by itself has acquired $30,000 as its assets.

From the business point of view it has also, at the same time, incurred a liability or debt of $30,000 to the owner.  This follows the business entity assumption where the owner is regarded as distinct from the business.

The capital or funds provided by the owner represents the owner's equity, i.e. the owner's financial interest or claim upon the assets of the business.

From the above, we see that all the assets of the business have been supplied by the owner himself.

The relationship of assets with the owner's equity can be expressed as follows:

Assets = Owner's Equity

or, in more specific terms,

Cash $30,000 = Capital $30,000

However, people other than the owner usually also supply some of the funds of the business.

For example: If A. John commences business with $30,000 cash from personal savings and $20,000 cash as loan from the bank -

The business, therefore, owns the following:

Assets: Cash $50,000

The business owes the following:

Owner's Equity: Capital $30,000 + Liabilities: Loan from Bank $20,000

From the above information, we derive the fundamental accounting equation as follows:

       Assets      =    Owner's Equity      +     Liabilities

i.e.     Cash $50,000     =     Capital $30,000     +     Loan $20,000      

This relationship between the total assets, total owner's equity and total liabilities of a business is called the accounting equation.

The above accounting equation expresses the fact that everything the business owns has been supplied by both the owner (owner's equity) and by external sources (liabilities).

Therefore, the total claim of the owner plus the claim of the creditors equal the total assets of the business.

It can be seen that the two sides of the equation will have the same totals.  This will always hold true no matter what transactions may take place.

The actual assets, owner's equity and liabilities may change but the total of the assets will always equal the total of owner's equity plus liabilities.

Elements in the Accounting Equation

Assets

Assets are items of value owned by the business.  They consist of property of all kinds like buildings, machinery, motor vehicles, stock of goods, debts owed by customers called debtors, cash at bank and cash in hand.

Liabilities

Liabilities are amounts owed by a business to external parties.  They include suppliers of credit purchases called creditors, accrued or unpaid expenses, loans, and bank overdraft. 

If the business withdraws an amount exceeding the balance in the current account maintained at the bank, the business is said to have taken an overdraft.  The overdraft represents a liability of the business to the bank.

Owner's Equity

An owner of a business can calculate his interest or net worth of his business by deducting the liabilities from the assets of the business.  This amount of the owner's interest or claim on the business is called the owner's equity.

Owner's equity can easily be derived from the accounting equation by rearranging the elements of the equation.

Owner's Equity = Assets - Liabilities

Owner's equity can increase when assets are introduced into the business through investment by the owner.

Alternatively, owner's equity can decrease through withdrawals of assets by the owner for personal use.

Business operations can also affect owner's equity.  Profits from business operations can increase owner's equity while a loss will reduce it.

Balance Sheet

A statement that lists all the assets, owner's equity and liabilities at a particular date is called a Balance Sheet.

The Balance Sheet is actually a detailed expression of the accounting equation.  It is a very important financial statement of the business  as it shows its financial position with respect to its assets, owner's equity and liabilities at a particular point in time.

The accounting equation and the Balance Sheet are two different ways of expressing the same thing.

It is not surprising to note here that because of the similar features of the accounting equation and the Balance Sheet, the former is sometimes referred to as the Balance Sheet equation.

Effects of Business Transactions on the Accounting Equation and the Balance Sheet

Business transactions are financial events which affect the assets, owner's equity and liabilities of a business.

When a transaction takes place in a business, at least two items in the accounting equation and the Balance Sheet will change.

At the same time, the equality between the assets and the claims against these assets will always be maintained.

Summary

The accounting equation is based on the business entity concept which assumes that the business, as a unit by itself, acquires its own assets through funds supplied by the owner or by external sources.