The Basic Accounting Equation

The fundamental accounting equation, also called the balance sheet equation, represents
the relationship between the assets, liabilities, and owner's equity of a person or business. It
is the foundation for the double-entry bookkeeping systemThe accounting equation is a basic
principle of accounting and a fundamental element of the balance sheet.

The accounting equation is considered to be the foundation of the double-entry accounting

system. The accounting equation shows on a company's balance sheet where by the total of
all the company's assets equals the sum of the company's liabilities and shareholders' equity.
Based on this double-entry system, the accounting equation ensures that the balance sheet
remains “balanced,” and each entry made on the debit side should have a corresponding
entry (or coverage) on the credit side. The accounting equation of a sole proprietorship is
assets = liabilities + owner's equity. For a corporation, the accounting equation is assets =
liabilities + stockholders' equity.

Assets: This is the value of the items that a company owns; they may be tangible or
intangible but belong to the company. What the business has or owns (equipment, supplies,
cash, and accounts receivable). Assets represent the economic resources of the entity
deployed to generate future income. An asset is a resource with economic value that an
individual, corporation, or country owns or controls with the expectation that it will provide
a future benefit. Assets are anything valuable that your company owns, whether it’s
equipment, land, buildings, or intellectual property. Assets mean anything that a
company possesses.

When you look at your assets, you’re trying to answer a simple question:

"How much do I have?"

If it has value, and you own it, it’s an asset.

Something valuable that an entity owns, benefits from, or has use of, in generating income.
For example, land, building, furniture and fixtures, plant and machinery, vehicles, debtors,
bills receivable, bank balance, cash, stock, etc.

A liability: This is a term for total value that a company is required to pay in the short term or
the long term. What the business owes outsiders (bank loan, accounts payable). Liabilities are
legally binding obligations that are payable to another person or entity. Liabilities include
loans, accounts payable, mortgages, deferred revenues, and accrued expenses. Liabilities refer
to the amount a business owes to the outsiders. Money that the company owes to others (e.g.
mortgages, vehicle loans). Liabilities are claims against assets. That is liabilities are existing
debts and obligations.

When you look at your accounting software or spreadsheets and look at your liabilities,
you’re asking:
"How much do I owe?"

If you’ve promised to pay someone in the future, and haven’t paid them yet, that’s a liability.

Owner’s Equity’: Shareholders Equity is the amount of money a company has raised through
its issue of shares. The ownership claim on total assts is known as owner’s equity. It is equal
to total assets minus total liabilities.Equity shows the assets that the company owns outright.
Alternatively, it is also the amount of retained earnings of a company. What the owner owns
(investment and business profit). It represents the owner’s own investment into the business.
Extending from the fundamental accounting equation, the owner’s equity equals the total
assets held as reduced by the external liabilities (Assets – Liabilities). For this reason, it is also
referred to as Net Assets. All adjustments for profits, reserves, and drawings reflect in this
account. Equity that portion of the total assets that the owners or stockholders of the company
fully own; have paid for outright: Capital or Owner’s Equity is the money that the owner brings
into the business.

Revenue or Income: Money the company earns from its sales of products or services, and
interest and dividends earned from marketable securities

Expenses: Money the company spends to produce the goods or services that it sells (e.g. office
supplies, utilities, advertising)

Transaction:
Any occurrence or incidence is known as event. There are two types of events i) financial
event ii) non-financial event. Financial event is known as transaction. Financial event are
recorded in the books of account as transaction. All business transaction shall have to be
recorded in terms of any monetary units.
The term ‘business transaction’ has been defined as any act that alters the financial position
of a business, where such alteration can be measured in terms of money. Thus, if goods are
purchased for cash Rs. 500 it constitutes a transaction because it alters the financial position
of the concern i.e., total cash resource is reduced by Rs. 500 and goods of the same value are
added to the list of assets. But if it is said that, 20 bags of sugar have been purchased, it cannot
constitute a business transaction until the value of each bag or 20 bags of sugar is ascertained.
Business transaction means the dealing of a trader in regard to money or money’s worth. It
must necessarily require two accounts or parties for its fulfillment and it involves receipt of a
benefit and the surrender of a similar benefit. The events; cash received and cash payment,
credit purchase and cash sales; and visible or invisible which alter the financial position is
known as transactions.
Accounting to modern theory method every transaction involves only the three balance sheet
elements, assets liabilities and proprietorship, causing increase and decrease in these elements.
Every event is not transaction but every transaction is an event:

Characteristics of transactions:
(i) Event must be measurable in terms of money: Purchased a pen it is not transaction. An
event in order to be a transaction must be amenable to calculation is terms of money value.
(ii) Financial change must be brought by the events. Bought machinery Tk. 100000. An event
in order to be a transaction must bring financial change in the business.
(iii) There must have two accounts or parties in each transaction: There is no transaction with
out two account or parties. If one receives something’s some other person has given it.
An event in order to be transaction must affect a lest to account or parties simultaneously
(iv) Transaction must be independent.
(v Invisible event: Transaction will be visible it is not necessary. Invisible events may be
transaction depreciation.
(vi) Hysterical event: An event in order to be transaction need not always be historical.

Impact of Transactions on Accounting Equation: (For Examples)

Business Transactions occur on a daily basis as a result of doing business. Items are purchased
or sold, credit is extended or borrowed, income is made or expenses are assumed. These
business transactions result in changes to the three elements of the basic accounting equation.
Assets = Liabilities + Owner’s Equity
1. A transaction that increases total assets must also increase total liabilities or owner’s
equity.
2. A transaction that decreases total assets must also decrease total liabilities or owner’s
equity.
3. Some transactions may increase one account and decrease another on the same side of
the equation i.e. one asset increases and another decreases.

Transaction 1: The owner deposits $50000 in the checking account to begin operations
Assets = Liabilities + Owner’s Equity
+$50000 $0 + $50000
The asset “Cash” is increased by $50000 and the Owner’s Equity is increased $50000. The
business owes the owner $5000.

Transaction 2: The business purchases a computer, on credit/on account, for $2500.

Assets = Liabilities + Owner’s Equity
+$2500 +$2500 $
The asset “Computers” is increased by $2500 and the liability is also increased $2500
Transaction 3: The business purchases office supplies using $550 cash.
Assets = Liabilities + Owner’s Equity
+$550
-$550
The asset “Office Supplies” is increased $550 and the asset “Cash” is decreased $550.
Transaction 4: A business purchases a building for $100,000 with a $25,000 cash down-
payment and a loan for the $75,000 outstanding.
Assets = Liabilities + Owner’s Equity
+$100,000 =LiabilitySS75,000
-$25,000
More than two accounts are affected by this transaction. The asset “Building” increases by
$100,000, the asset “Cash” decreases by $25,000, and the liability “Bank Loan” increases by
$75,000. The net result is that both sides of the equation increase by $75K.
The expanded Accounting Equation looks like this:
Assets = Liabilities + Owner’s Equity + Revenues – Expenses – Drawings
Let’s analyze some transactions involving these types of accounts:

Transaction 5: The business sells goods for $1,2000 cash.

Assets = Liabilities + Owner’s Equity
+$12000 +$12000 (Revenue)
The asset “Cash” is increased $12000 and the revenue increases $12000.

Transaction 6: The business pays its rent monthly rent of $950 cash.
Assets = Liabilities + Owner’s Equity
-$950 -$950 (Expense)
The asset “Cash” is decreased $950 and the expense inecreases $950.
Transaction 7: The business’ owner withdraws $2,000 for his personal use.
Assets = Liabilities + Owner’s Equity
-$2000 -$2000
The asset “Cash” is decreased $2000 and the drawing decreases Owner’s Equity $2000.
Impact of Transactions on Accounting Equation: (For Examples)
Business Transactions occur on a daily basis as a result of doing business. Items are purchased
or sold, credit is extended or borrowed, income is made or expenses are assumed. These
business transactions result in changes to the three elements of the basic accounting equation.
1. A transaction that increases total assets must also increase total liabilities or owner’s
equity.
2. A transaction that decreases total assets must also decrease total liabilities or owner’s
equity.
3. Some transactions may increase one account and decrease another on the same side of
the equation i.e. one asset increases and another decreases.

Transaction 1: The owner deposits $5000 in the checking account to begin operations
Assets = Liabilities + Owner’s Equity
+$5000 $0 + $5000
The asset “Cash” is increased by $5000 and the Owner’s Equity is increased $5000. The
business owes the owner $5000.

Transaction 2: The business purchases a computer, on credit, for $2500.

Assets = Liabilities + Owner’s Equity
+$2500 +$2500 $
The asset “Computers” is increased by $2500 and the liability is also increased $2500 because
the business now owns the store $2500.

Transaction 3: The business purchases office supplies using $550 cash.

Assets = Liabilities + Owner’s Equity
+$550
-$550
The asset “Office Supplies” is increased $550 and the asset “Cash” is decreased $550.
Transaction 4: A business purchases a building for $100,000 with a $25,000 cash down-
payment and a loan for the $75,000 outstanding.
Assets = Liabilities + Owner’s Equity
+$100,000 +75,000
-$25,000
More than two accounts are affected by this transaction. The asset “Building” increases by
$100,000, the asset “Cash” decreases by $25,000, and the liability “Bank Loan” increases by
$75,000. The net result is that both sides of the equation increase by $75K.
The expanded Accounting Equation looks like this:
Assets = Liabilities + Owner’s Equity + Revenues – Expenses – Drawings
Let’s analyze some transactions involving these types of accounts:

Transaction 5: The business sells goods for $1,200 cash.

Assets = Liabilities + Owner’s Equity
+$1200 +$1200 (Revenue)
The asset “Cash” is increased $1200 and the revenue increases Owner’s Equity $1200.

Transaction 6: The business pays its rent monthly rent of $950 using a company check.
Assets = Liabilities + Owner’s Equity
-$950 -$950 (Expense)
The asset “Cash” is decreased $950 and the expense decreases Owner’s Equity $950.
Transaction 7: The business’ owner withdraws $2,000 for his personal use.
Assets = Liabilities + Owner’s Equity
-$2000 -$2000 (Revenue)
The asset “Cash” is decreased $2000 and the drawing decreases Owner’s Equity $2000.