The Accounting Equation and How Transactions Impact It

The Accounting Equation

Let’s explore the accounting equation, which ensures that all business accounts remain balanced. We'll break down this equation in steps to enhance your understanding. To start a business, the owner typically invests some money to finance operations. This initial investment is referred to as the Owner’s Equity or Capital. Additionally, this investment is considered an Asset for the company. This relationship can be represented by the equation:

Assets = Owner’s Equity

If the business owner decides to close the business, they would be entitled to all the assets. Now, suppose the owner decides to take a loan from the bank. When the business takes the loan, its Assets increase by the amount of the loan. However, this loan also becomes a Liability for the company. This can now be represented by the equation:

Assets = Liabilities + Owner’s Equity

At this point, the company’s assets consist of both the money invested by the owner (Owner’s Equity) and the loan taken from the bank (Liability). Liabilities are listed before Owner’s Equity because creditors have the first claim on assets. If the business were to close down, liabilities would be paid off first, and anything remaining (assets) would belong to the owner.

Double-entry Bookkeeping

Modern accounting principles are based on a system created by an Italian monk named Fra Luca Pacioli over 500 years ago. Pacioli developed what we now know as the Double-entry System of accounting. He explained that every transaction, whether a sale or a collection, involves two offsetting sides. Each transaction requires a two-part "give-and-get" entry. Here’s a simple explanation:

Suppose you take a loan of Rs. 50,000 from the bank. As previously discussed:

Assets = Liabilities + Owner’s Equity

Since the company borrowed Rs. 50,000, this amount is now a liability for the company. At the same time, this Rs. 50,000 becomes an asset for the company. If we record this in our accounts, we would credit Rs. 50,000 to an account called "Loan Taken from the Bank" (Liability) and debit Rs. 50,000 to an account called "Cash Saved in the Bank" (Asset). As you can see, we created two entries: the first shows the source of the money, and the second shows the destination of the money received.

In a double-entry accounting system, every transaction is recorded as both a debit and a credit. Even the simplest transaction will involve a debit and a credit. In simpler terms, a debit is the application of money, and a credit is the source of money.

All business transactions, however simple or complex they are, result in a change in the three basic elements of the equation. This is well explained with the help of the following series of examples:

• Mr. Prasad commenced business with a capital of Rs.3,000: the result of this transaction is that the business, being a separate entity, gets cash-asset of rs.30,000 and has to pay to Mr. Prasad Rs.30,000, his capital. This transaction can be expressed in the form of the equation as follows:

Capital	=	Assets
Prasad		Cash
30,000		30,000

• Purchased furniture for Rs.5,000: the effect of this transaction is that cash is reduced by Rs.5,000 and a new asset viz. Furniture worth Rs.5,000 comes in, thereby, rendering no change in the total assets of the business. The equation after this transaction will be: 

Capital	=	Assets
Prasad		Cash
30,000		25000
		Furniture
		5000
30000		30000

• Borrowed Rs.20,000 from Mr. Gopal: as a result of this transaction both the sides of the equation increase by Rs.20,000; cash balance is increased and a liability to Mr. Gopal is created. The equation will appear as follows:  (Liabilities + Capital = Assets)

Capital	=	Assets
Prasad		Cash
30,000		45000
		Furniture
+  Liabilities		5000
Loan
20000
50000		50000

• Purchased goods for cash Rs.30,000: this transaction does not affect the liabilities side total nor the asset side total. Only the composition of the total assets changes i.e. Cash is reduced by Rs.30,000 and a new asset viz. Stock worth Rs.30,000 comes in.  The equation after this transaction will be as follows:

Capital	=	Assets
Prasad		Cash
30,000		15000
		Furniture
+ Liabilities		5000
Loan		Stock
20000		30000
50000		50000

• Goods worth Rs.10,000 are sold on credit to Ganesh for Rs.12,000. The result is that stock is reduced by Rs.10,000 a new asset namely debtor (Mr. Ganesh) for Rs.12,000 comes into picture and the capital of Mr. Prasad increases by Rs.2,000 as the profit on the sale of goods belongs to the owner. Now the accounting equation will look as under:

Capital	=	Assets
Prasad		Cash
30,000		15000
Profit		Furniture
2000		5000
+ Liabilities		Stock 20000
Loan		Debtors
20000		12000
52000		52000

• Paid electricity charges Rs.300: this transaction reduces both the cash balance and Mr. Prasad’s capital by Rs.300. This is so because the expenditure reduces the business profit which in turn reduces the equity. The equation after this will be:

Capital	=	Assets
Prasad		Cash
30,000		14700
Profit		Furniture
1700		5000
+ Liabilities		Stock 20000
Loan		Debtors
20000		12000
51700		51700

This illustrates that regardless of the nature of the transaction, the accounting equation always balances and should balance. The system of recording transactions based on this concept is known as the double-entry system.

Expenses and revenue also affect the accounting equation. Their effect is always on Capital. A business incurs expenses in its normal operations, such as salary, rent, insurance, postage, wages, and repairs. Payment of these expenses reduces cash and consequently reduces the net income of the business. All net income is attributed to the proprietor and is added to the capital account, so expenses reduce capital. Similarly, the business receives revenue, such as rent or commission, which increases cash and net income, thus increasing capital.

The accounting equation is impacted by every business transaction. Any increase or decrease in assets, liabilities, and capital can be identified by preparing the accounting equation. It demonstrates that every business transaction adheres to the dual aspect concept of accounting and serves as the basis for preparing the Balance Sheet.

In our next article, "Golden Rules of Accounting Using Debit and Credit", we’ll simplify these key concepts to help you understand them easily.