Chapter – 2

Accounting Equation

Contents:

2.1 Basic Accounting Terminology

2.2 Accounting Equation

In order to understand the Accounting concepts it’s necessary to have the basic understanding of
accounting terminology.

2.1 Basic Accounting Terminology:

1. Entity: An entity is something that has a distinct, separate existence, that performs economic
activities.
2. Event: It is the happening of consequence to an entity.
3. Transaction: A transaction is an agreement, communication, or movement carried out between
separate entities or objects, often involving the exchange of items of value, such as information,
goods, services and money.
4. Voucher: It is the document which serves as an evidence for transaction.
5. Entry: It is the record made in the books of accounts in respect of a transaction or event.
6. Assets: In business and accounting, assets are everything of value that is owned by a person or
company. The two major asset classes are:
a. Tangible assets: Tangible assets contain various subclasses, including current assets
and fixed assets. Current assets include inventory, while fixed assets include such items
as buildings and equipment.
b. Intangible assets: Intangible assets are nonphysical resources and rights that
have a value to the firm because they give the firm some kind of advantage in the market
place. Examples of intangible assets are goodwill, copyright, trademarks, patents and
computer programs and financial assets, including such items as accounts receivable,
bonds and stocks.
7. Liabilities: In financial accounting, a liability is defined as an obligation of an entity arising from
past transactions or events, the settlement of which may result in the transfer or use of assets,
provision of services or other yielding of economic benefits in the future. Liabilities are reported
on a balance sheet and are usually divided into two categories:
a. Current liabilities — these liabilities are reasonably expected to be liquidated within a
year. They usually include payables such as wages, accounts, taxes, and accounts
payables, unearned revenue when adjusting entries, portions of long-term bonds to be
paid this year, short-term obligations (e.g. from purchase of equipment), and others.
b. Long term liabilities — these liabilities are reasonably expected not to be liquidated within
a year. They usually include issued long-term bonds, notes payables, long-term leases,
pension obligations, and long-term product warranties.
8. Capital: It is the excess of assets over external liabilities.
 9. Drawings are the total amount of cash or goods or any other asset withdrawn by the proprietor or
the partner of the partnership enterprise for personal use.
10. Purchases refer to the total amount of goods obtained by an enterprise for resale or for use in
the production of goods or rendering of services in the normal course of business. It may be for
cash or credit.
11. Sales refer to the amount for which goods are sold or services are rendered. It may be for cash
or credit.
12. Stock refers to the tangible property held for sale in the ordinary course of business or for
consumption in the production of the goods or services.
13. Trade creditors refer to the person to whom the amounts are due for goods purchased or
services rendered on credit basis.
14. Trade debtors refer to the person from whom the amounts are due for goods purchased or
services rendered on credit basis.
15. Receivables: includes both trade debtors and bills receivable.
16. Payables: includes both trade creditors and bills payable.
17. Expenditure is the costs incurred in acquiring an asset or service in the form of outflow or
depletion of assets or incurrence of liability.
18. Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
19. Expenses decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrence of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants
20. Gains are increase in equity (not assets)from incidental transaction of an entity and from all other
transaction and other events and circumstances affecting the entity during the accounting period
except that result from revenues or investment by equity participants.
21. Losses are decrease inequity (not assets)from incidental transaction of an entity and from all
other transaction and other events and circumstances affecting the entity during the accounting
period except that result from revenues or investment by equity participants.
22. Revenue refers to the amount charged for the goods sold or services rendered or permitting
others to use enterprise’s resources yielding interest, royalty and dividend.
23. Net Profit is the excess of revenue over expenses
24. Net Loss is the excess of expenses over revenue.

2.2 Accounting Equation:

The basic accounting equation is the foundation for the double entry book keeping system. It shows how
assets were financed:
• Either by borrowing money from someone (liability) or
• By paying your own money (shareholders’ equity).
Assets = Liabilities + (Shareholders or Owners equity)

For example: A student buys a computer for $945. This student borrowed $500 from his best friend and
saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity
$445.
The formula can be rewritten:

Assets − Liabilities = (Shareholders or Owners equity)

Now it shows owner’s interest is equal to property (assets) minus debts (liabilities). Since in a company
owners are shareholders, owner’s interest is called shareholder’s equity. Every accounting transaction
affects at least one element of the equation, but always balances. Simplest transactions also include.
Transaction Shareholder’s
Assets Liabilities Explanation
Number Equity

1 + 6,000 + 6,000 Issuing stocks for cash or other assets

Buying assets by borrowing money (taking a loan

2 + 10,000 + 10,000
from a bank or simply buying on credit)

Selling assets for cash to pay off liabilities: both

3 - 900 - 900
assets and liabilities are reduced

Buying assets by paying cash by shareholder’s

4 + 1,000 + 400 + 600
money (600) and by borrowing money (400)

5 + 700 + 700 Earning revenues

Paying expenses (e.g. rent or professional fees) or

6 - 200 - 200
dividends

Recording expenses, but not paying them at the

7 + 100 - 100
moment

8 - 500 - 500 Paying a debt that you owe

Receiving cash for sale of an asset: one asset is

9 0 0 0 exchanged for another; no change in assets or
liabilities

These are some simple examples, but even the most complicated transactions can be recorded in a
similar way. This equation is behind debits, credits, and journal entries.
Also, the equation can be rewritten as:
Assets = Liabilities + Owners equity + (Revenue – Expenses)

OR
Assets + Expenses = Liabilities + Owners equity + Revenue

This is often referred to as the expanded accounting equation, because it yields the breakdown of the
equity component of the equation