The accounting equation represents the relationship between the assets, liabilities and capital of a business and it is fundamental to the application of double entry bookkeeping where every transaction has a dual effect on the financial statements. The purpose of this article is to consider the fundamentals of the accounting equation and to demonstrate how it works when applied to various transactions.
You should refer to your learning materials for more detail and to learn about the journal entries that would be required to record the transactions outlined below.
In its simplest form, the accounting equation can be shown as follows:
Capital = Assets – Liabilities
Capital can be defined as being the residual interest in the assets of a business after deducting all of its liabilities (ie what would be left if the business sold all of its assets and settled all of its liabilities). In the case of a limited liability company, capital would be referred to as ‘Equity’.
Capital essentially represents how much the owners have invested into the business along with any accumulated retained profits or losses. For example, if you were to start a sole trade business with a $1,000 investment then on the first day of trading the accounts of the business would show that it has $1,000 of cash available and that this came from an investment made by you. The capital would ultimately belong to you as the business owner.
The accounting equation can also be rearranged in several ways, including:
Assets = Capital + Liabilities
In this format, the formula more clearly shows how the assets controlled by the business have been funded. That is, through investment from the owners (capital) or by amounts owed to creditors (liabilities). You may also notice two other interesting points regarding the formula being laid out in this way:
Drawings are amounts taken out of the business by the business owner. They will therefore result in a reduction in capital.
Income and expenses relate to the entity’s financial performance. Individual transactions which result in income and expenses being recorded will ultimately result in a profit or loss for the period. The term capital includes the capital introduced by the business owner plus or minus any profits or losses made by the business. Profits retained in the business will increase capital and losses will decrease capital. The accounting equation will always balance because the dual aspect of accounting for income and expenses will result in equal increases or decreases to assets or liabilities.
The accounting equation can be expanded to incorporate the impact of drawings and profit (ie income less expenses):
Assets = Capital introduced + (Income – Expenses) – Drawings + Liabilities
We will now consider an example with various transactions within a business to see how each has a dual aspect and to demonstrate the cumulative effect on the accounting equation.
Anushka began a sole trade business on 1 January 20X1. During the first month of trading, the following transactions took place:
Explain how each of the above transactions impact the accounting equation and illustrate the cumulative effect that they have.
The impact of each of the above transactions has been outlined below, followed by a summary of the cumulative effect of these transactions on the accounting equation:
1. The cash (asset) of the business will increase by $5,000 as will the amount representing the investment from Anushka as the owner of the business (capital).
2. $10,000 of cash (asset) will be received from the bank but the business must also record an equal amount representing the fact that the loan (liability) will eventually need to be repaid.
3. The assets of the business will increase by $12,000 as a result of acquiring the van (asset) but will also decrease by an equal amount due to the payment of cash (asset).
4. The inventory (asset) of the business will increase by the $2,500 cost of the inventory and a trade payable (liability) will be recorded to represent the amount now owed to the supplier. (Note that in the accounting records, the purchase of inventory may be recorded as an expense initially and then an adjustment made for closing inventory at the year-end. Any inventory not sold will ultimately be recorded as an asset though).
5. Anushka will record revenue (income) of $400 for the sale made. A trade receivable (asset) will be recorded to represent Anushka’s right to receive $400 of cash from the customer in the future. As inventory (asset) has now been sold, it must be removed from the accounting records and a cost of sales (expense) figure recorded. The cost of this sale will be the cost of the 10 units of inventory sold which is $250 (10 units x $25). The difference between the $400 income and $250 cost of sales represents a profit of $150. The inventory (asset) will decrease by $250 and a cost of sale (expense) will be recorded. (Note that, as above, the adjustment to the inventory and cost of sales figures may be made at the year-end through an adjustment to the closing stock but has been illustrated below for completeness).
6. Interest (ie finance costs) are an expense to the business. Therefore cash (asset) will reduce by $60 to pay the interest (expense) of $60.
7. The business has paid $250 cash (asset) to repay some of the loan (liability) resulting in both the cash and loan liability reducing by $250.
8. Cash (asset) will reduce by $10 due to Anushka using the cash belonging to the business to pay for her own personal expense. As this is not really an expense of the business, Anushka is effectively being paid amounts owed to her as the owner of the business (drawings).
The cumulative effect of each of the above transactions on the accounting equation has been summarised below:
As you can see, no matter what the transaction is, the accounting equation will always balance because each transaction has a dual aspect. Often, more than one element of the accounting equation is impacted but sometimes, like with transaction 3, the same part of the equation (in this case assets) goes up and down, making it look like nothing has happened. However, the detail of the transaction will be presented in different places in the financial statements (ie the cash balance within current assets will reduce and the motor vehicle cost balance within non-current assets will increase).
Taking time to learn the accounting equation and to recognise the dual aspect of every transaction will help you to understand the fundamentals of accounting. If you are unsure about what accounts will be affected by a particular transaction, it can sometimes be helpful to think about just one of the accounts which might be affected, for example cash (asset), and then use your knowledge of the accounting equation to work out the other one. Whatever happens, the transaction will always result in the accounting equation balancing.