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Sunday, 7 March 2010

The Accounting Equation - How it Works

As its name suggests, the accounting equation should always balance. If it does not, it suggests that there are basic errors in the accounting system. In other words, it suggests a fundamental error. The accounting equation holds that what the business owes (to the owner and creditors) should be equivalent to what it owns. Each transaction has an equal and corresponding effect on either side of the accounting equation.

When drawing up accounts, there is a left and right side of the account. By convention, the left side of the account is the debit side while the right side is the credit side. If you enter a transaction on the debit side of an account, there should be a transaction on the credit side of another account as well. It is important to note the definition of debit and credits as well.

- Debit- Increase in an asset, increase in expense, increase in drawings
- Decrease in capital, decrease in revenue, decrease in liability
- Credit- Increase in capital, increase in revenue, increase in liability
- Decrease in asset, decrease in expense, decrease in drawings

To demonstrate the principle behind the accounting equation, it is best to use an example. Assume that you wish to open a business and you have £20,000.00 cash to invest. Recall that the business' activities are separate from yours (as the owner). Therefore, your new business receives capital from you to the tune of £20,000.00. Capital is what the business owes the owner. As such, your business owes you £20,000.00. However, the business can use that money for the purposes of trade; the business owns £20,000.00 as well. Whatever a business owns is an asset.

So far, we have Assets = Capital, which is £20,000.00 on either side of the equation (Dr Asset, Cr Capital). Suppose the business buy goods for sale. The business uses £3,000.00 cash to purchase the goods. This would only affect the left side of the equation, because one asset (cash) is used to purchase another (goods). Assets would still be £20,000.00, but the transaction would be to credit cash (decrease in cash) and debit purchases. The business owns its purchases, so in the balance sheet, it should be recorded as Stock or Goods. Note that the business still owes £20,000.00 to the owner.

The business buys a motor vehicle, using a loan for £5,000.00. The motor vehicle is an asset to the business, but it was purchased on credit. Therefore, the assets of the business would increase by £5000.00, while the liabilities of the business would increase from zero to £5000.00. The accounting equation would be:

Assets (£17,000.00 cash + £3,000.00 goods + £5000.00 motor vehicle) = Capital (£20,000.00) + Liabilities (5000.00).

Now, let us assume that the owner takes exactly half of the goods (£1500.00) from the business and the business sells the remaining goods for £2000.00 cash. The £1500.00 that the owner took is drawings. Now, some folks think that the drawings can only be cash, but drawings are anything that the owner takes from the business, regardless of what it is called. The latter part comes in because if the owner works in the business and pays himself, he might call it wages/ salary. However, because of the business entity concept, which treats the owner's activities as separate from the business, that is drawings as well.

In this case, drawings reduce the stock of the business (asset reduction). Drawings also reduce capital. Therefore, the revised accounting equation would be:

Assets (£17,000.00 cash + £1500.00 goods + £5000.00 motor vehicle) = Capital (£18,500.00) + Liabilities (£5000.00)

Now, we also mentioned that the business sold the remaining goods (worth £1500.00) for £2000.00 dollars cash. Therefore, that transaction increases cash by £2000.00 but reduces to stock from £1500.00 to zero (Increase in cash: Dr £2000.00; Decrease in stock: Cr £1500.00). Wait! There is a difference of £500.00. Notice that the £2000.00 effectively represents sales and £1500.00 represents purchases. Therefore, the additional £500.00 is gross profit. For the accounting equation to balance, that profit must go on the right side. The business did not borrow the £500.00, so it cannot be a liability. Profit is what the business owes to the owner. As such, retained profit increases the capital by £500.00.

That example shows the logic behind the accounting equation. Every business transaction has an effect on the accounting equation and this is reflected in the Statement of Financial Position (Balance Sheet). However, since an entity performs several transactions within a period, it is difficult and impractical to create a balance sheet after every transaction. This is done at the end of the period to show the assets of a business in relation to its liabilities.

Assets, capital and liabilities are the building blocks of the accounting equation.

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