ACCOUNTING EQUATION

UNDERSTANDING THE ACCOUNTING EQUATION

CHAPTER 4

Following the double entry accounting system, the debit and the credit in accounting records should always be equal. In other words, the total assets (debit balance accounts) of a business should be equal to the total liabilities (credit balance accounts). This relation between assets and liability can be expressed as:

Assets = liabilities + capital

This equation is known as the accounting equation.

According to the accounting equation, an increase or decrease in the assets of a business is always equal to the accounting equation, an increase or decrease in the liabilities of the business.

It may be observed that aby increase in assets would either result in a similar increase in liabilities or a reduction in any other assets in case liabilities do not increase.

Let us understand with the help of an example. ABC & Co. has cash amounting to rs. 50000 mr. sharma, the proprietor, provided this cash in the form of capital. Now since ABC & Co. and mr. sharma are separate entities, ABC &Co. has a liabilities of rs. 50000 towards mr. sharma in this case, the accounting equation becomes:

ASSETS	LIABILITIES + CAPITAL
Cash= rs. 50000	Capital = rs 50000
Total= rs. 50000	Total = 50000

Now, suppose the company purchase a van rs. 2000 so the assets side of the accounting equation increase by Rs. 2000. The payment has been made in cash, thus, cash balance decrease by Rs. 2000 terefore, the net effect on total assets remains nil and the equation become :

ASSETS	LIABILITIES + CAPITAL
Cash = RS. 48000 Van = RS. 2000	Capital = RS. 50000
Total = RS. 50000	Total = RS. 50000

Next, ABC & CO. purchase furniture wroth RS. 24000 from furniture world INC. on credit thus, the assets side of the accounting equation increase by RS. 24000 in the form of furniture. On the other hand, since the purchase is on credit, creditors amounting to RS. 24000 appear on the liabilities side of accounting equation. In this case, the accounting equation becomes:

ASSETS	LIABILITIES + CAPITAL
Cash = RS. 48000 Van = RS. 2000 Furniture= RS. 24000	Capital = RS. 50000 Creditors = RS. 24000
Total = RS. 74000	Total = RS. 74000