Definition and Explanation of Accounting Equation

Topics: Asset, Balance sheet, Liability Pages: 5 (1220 words) Published: November 18, 2011
Accounting Equation:
Definition and Explanation of Accounting Equation:
Dual aspect may be stated as "for every debit, there is a credit." Every transaction should have twofold effect to the extent of the same amount. This concept has resulted in accounting equation which states that at any point of time the assets of any entity must be equal (in monetary terms) to the total of equities. In other words, for every business enterprise, the sum of the rights to the properties is equal to the sum of the properties owned. The properties of the business are called "assets". The rights to the properties are called "equities". Equities may be sub-divided into two principle types: The rights of the creditors and the rights of the owners. The equity of the creditors represents debts of the the business and are called liabilities. The equity of the owner is called capital, or proprietorship or owner's equity. The formula know as the accounting equation, thus arrived at is as follows: Assets = Equities

Assets = Liabilities + Proprietorship
Another method of demonstrating the mathematical relationship involves a simple variation in the form of equation. Again it begins with the position that every business owns or has interest in certain assets. It also owes certain amounts to its creditors. The difference between what it owns and what it owes represents the owner's capital or proprietorship. Thus the original equation is changed into: Assets - Liabilities = Proprietorship

Effects of Transactions on the Accounting Equation:
Each and every business transaction affects the elements of accounting equation. The effect is shown by the use of (+) or (-) placed against the elements affected. Note particularly that the equation remains in balance after each transaction. The accounting equation can be understood with the help of the following example: Example:

Transaction 1:
Mr. Riaz commences his business with cash $50,000. This is an example of investment of asset in the business by the owner. The effect of this transaction on the accounting equation is that cash asset is increased by $50,000 and the proprietorship (Riaz's capital) is also increased by the same amount such as: Assets=Liabilities+Proprietorship

Cash Riaz, Capital
+ 50,000=---- + 50,000
Note that assets and equities increased by equal amounts
Transaction 2:
Purchased furniture on cash $10,000. This transaction effected accounting equation as the increase in one new asset furniture and decreases in assets cash with the same amount. Thus Assets=Liabilities+Proprietorship

CashFurniture Riaz, Capital
+ 50,000 =---- + 50,000
- 10,000+ 10,000
40,000+ 10,000= 50,000
Note that this transaction has affected assets side only and no change is made in equities side of the equation. Transaction 3:
Purchased merchandise for cash $10,000. This transaction will introduce a new element (merchandise) on the assets side and decrease the cash by $10,000. Assets=Liabilities+Proprietorship
CashFurnitureMerchandise Riaz, Capital
+ 40,000+ 10,000 =---- + 50,000
-10,000--+ 10,000
30,000 + 10,000= 50,000
Note that this transaction has affected assets side only and no change is made in equities side of the equation. Transaction 4:
Purchased merchandise on account (on credit) $5,000.
CashFurnitureMerchandise Creditors Riaz, Capital
+ 30,000+ 10,000+ 10,000= + 50,000
+ 5,000 + 5,000
30,000+10,000+ 15,000=+ 5,000 + 50,000
Note that this transaction has affected assets side and liabilities. Both the sides of equation has increased with the same amount. Transaction 5:
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