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Accounting equation

The properties owned by a business are called assets and the rights or claims to the properties are referred to as equities. For every business, the sum of the rights to the properties is equal to the sum of properties owned. The relationship between the two may be expressed in the form of an equation. This equation is commonly known as accounting equation and is written as follows:

Assets = Equities

The equities in the above equation may be divided into two parts:

  1. The rights of the creditors.
  2. The rights of the owners.

The rights of the creditors represent debts of the business and are called liabilities and the rights of the owners are called capital or owner’s equity. By substituting the two types of equities, we get the following well known form of accounting equation:

Assets = Liabilities + Owner’s equity

Creditors have preferential rights over the assets of the business so it is appropriate to place liabilities before the capital or owner’s equity in the equation. If an item of the accounting equation given above is missing, we can easily compute it by solving the equation for that item. Consider the following example:

Example 1

accounting-equation1

Required: Compute the missing figures in the above equations.

Solution:

a: Owner’s equity = $5,000 ($34,000 – $29,000)
b: Liabilities = $4,200 ($21,500 – $17,300)
c: Assets = $50,000 ($36,000 + $14,000)
d: Liabilities = $6,550 ($15,975 – $9,425)
e: Assets = $21,000 = ($13,678 + $7,322)

The effect of transactions on the accounting equation

As the business transactions occur, the amounts of the assets, liabilities and owner’s equity change but the overall equation always remains balanced. The effects of changes in the items of the equation can be shown by the use of + or – signs placed against the affected items. Now we take an example and see how various transactions affect the amounts of the elements in the accounting equation.

Example 2

On January 01, 2016, Mr. Sam starts a trading business in the name of “Sam Enterprise” with an initial investment of $100,000. At this time, there is no external equity or liability of the Sam enterprise. The only equity is the capital invested by Sam i.e., owner’s equity amounting to $100,000. The accounting equation at the start of the business would therefore like the following:

On January 02, Mr. Sam purchases a building for $50,000 to be used in his business. The impact of this transaction is the decrease in an asset (i.e., cash) and addition of another asset (i.e., building). After this transaction, the items of the equation would be affected as follows:

On January 05, Mr. Sam purchases merchandise for $20,000 on credit basis. As a result of this transaction, an asset in the form of merchandise increases resulting an increase in the total assets. On the other side of the equation, a liability i.e., accounts payable is created and the items of accounting equation of Sam enterprise would be affected as follows:

On January 10, Sam Enterprise sells merchandise for $10,000 cash and earns a profit of $1,000. As a result of this transaction, an asset (i.e., cash) increases by $10,000 while another asset ( i.e., merchandise) decreases by $9,000 (the original cost). This transaction also brings a profit of $1,000 for Sam Enterprise that would increase the owner’s equity element of the equation. The resulting equation would look like the following:

On January 12, Sam Enterprise pays $10,000 cash to its accounts payable. This transaction would reduce an asset (cash) and a liability (accounts payable). The equation items would be affected as follows:

On January 18, Merchandise costing $5,000 are sold for $6,000 on credit. It reduces an asset (merchandise) but also creates a new asset (accounts receivable) valuing $6,000. The difference between the sale price and the cost of merchandise is the profit of the business that would increase the owner’s equity by $1,000 (6,000 – $5,000). The accounting equation after this transaction would look like the following:

On January 20, merchandise costing $500 are stolen by a thief. The loss of goods by theft would reduce both merchandise and owner’s equity and change the equation elements as follows:

On January 22, Sam enterprise pays $9,500 cash to his creditors and receives a cash discount of $500. This transaction would reduce cash by $9,500 and accounts payable by $10,000. The difference of $500 is the cash discount that would be added to the owner’s equity.

On January 25, a loan of $5,000 is obtained from a bank. This transaction brings cash into the business and also creates a new liability called bank loan.

On 28 January, merchandise costing $5,500 are destroyed by fire.The effect of this transaction on accounting equation is the same as that of loss by fire occurred on January 20. The merchandise would decrease by $5,500 and owner’s equity would also decrease by the same amount.

On January 31, electricity bill of $500 is paid. This transaction would decrease cash and owner’s equity.

Example 3

The assets, liabilities and owner’s equity of Modern Enterprises at the beginning of July 2016 are given below:

Cash: $27,150; Accounts receivable: $3,900; Supplies: $1,850; Furniture: $3,100; Accounts payable: $3,000 and owners equity: $33,000.

The following transactions were performed during the month of July 2016.

July 01: Merchandise purchased on account from Mr. A $3,700.
July 10: Received cash from accounts receivable $2,350 and allowed discount $150.
July 16: Sold merchandise on account $2,400 to Mr. X. The cost of these merchandise were $2,000.
July 20: Defective merchandise returned to Mr. A $700.
July 27: Recorded depreciation on furniture $150.
July 29: Paid cash to accounts payable $1,900 and received discount $100.
July 30: Merchandise returned by Mr X $480. The cost of these merchandise were $400.
July 31: Cost of supply on hand at the end of July was $1,200.

Required: Show the effect of the above transactions on the accounting equation of Modern Enterprises.

accounting-equation-example

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