Accounting Equation- Concept, Meaning and Formulas

Hello Guys, Today we discuss about Accounting Equation- Concept, Meaning and Formulas. Accounting Equation is the basis for Double Entry System of Book Keeping. Total assets of the business firm are provided by the lenders and the owners. Therefore, at any point of time, the total assets of a business are equal to its total liabilities. Liabilities or loans to the outsiders are known as "liabilities" but liability to the owners, in accounting is referred to as "capital".

Accounting Equation

We Learn-

• Meaning of Accounting Equation
• Transactions affecting two items
• Transactions affecting more than two items

Meaning of Accounting Equation

Accounting Equation also known as Balance Sheet Equation, which is a mathematical expression which shows the assets and liabilities of the firm are equal, here liabilities include owner's equity and claims from outsiders. It means total claims (claim of outsiders and claim of proprietors) will always equal to the total assets of the firm. 

The Accounting Equation is based on Double Entry System of Accounting, which says that every transaction has two aspects, i.e, Debit and Credit, it holds that every debit there is a credit of equal amount and vice versa. It helps to prepare a balance sheet, that's why it is also known as Balance Sheet Equation. The claims, also known as Equities which are of two types:

• Owner's Equity/ Capital
• Amount from outsiders (Outsider's Equity)

The accounting Equation is the simplified breakdown of the elements entered in the balance sheet. It shows the relationship between company's Assets, Liabilities(Owner's Equity+ Amount owed to outsiders). We can express this formula of Accounting Equation as follows:

Assets=  Owner's Equity + Liabilities 

OR

Liabilities= Assets- Capital     or    Capital= Assets- Liabilities

The above equation is known as Accounting Equation. An Accounting Equation always holds true with every change that occured due to a transaction entered into, this happens due to the Double Entry System of Accounting in which we records both the aspects of any financial transaction, there is always a two way effect of any transaction entered into the business. Let us take an example of an accounting equation-

ABC Ltd. holds the assets of Rs 3,20,000/- and the outside liabilities of ABC Ltd. are Rs 1,15,000/-. Calculate the Owners's Equity

Assets= Owner's Equity + Liabilities

3,20,000= Owner's Equity + 1,15,000

Owner's Equity = 3,20,000 - 1,15,000

Owner's Equity = 2,05,000

👉Also read Golden Rules of Accounting Explained.

A transaction may effect either both sides of the equation by the same amount or one side of the equation only, from this view transaction can be divided into two parts:-

• Transactions Affecting Two items
• Transactions Affecting more than two items

👉Also Read Generally Accepted Accounting Principles(GAAPs)
👉Also Read International Financial Reporting Standards(IFRS)
👉Also Read Cash and Accrual Basis of Accounting

Transactions Affecting Two Items

In this there are those transactions that affect two items of the accounting equation as the name also suggests

1. Increase in Asset, Increase in Liability- Rama furnitures purchases material from Dhiru Ltd on credit, by this transaction Asset(Stock) is increased and on the other hand Liability(Creditor) has also increased. This transaction affect two items of the accounting equation at opposite sides.
2. Increase in Asset, Increase in Owner's Equity- Introduction of capital by the proprietor into the business results in increase in asset(Cash/Bank) and increase in Liability(capital), because capital invested by owner is liability for a business.
3. Decrease in Liability, Decrease in Assets- Rama furnitures pay the due amount of Dhiru Ltd by cash, this transaction also affect two items of the accounting equation at opposite sides.On one side liability(Creditor) was decreased and on the other hand Asset(Cash) was also decreased.
4. Decrease in Owner's capital, Decrease in Assets- The amount of Rs 12000/-  was drawn by proprietor for his personal use. In this case on one side liability(Capital) was decreased and on the other side Asset(Cash/Bank) was also decreased.

👉Must Read Journals and Ledger explained notes.

Transactions Affecting more than Two Items

In this type of transactions, A transaction effect more than two items at a time. Let us take an Example to understand this:

Sohan & Co. sale goods in Cash for Rs 55,000/- in which cost of those goods are Rs 50,000/- only  and they add the profit margin of 10% on the cost of  goods sold , 50,000*10% = 5,000.This transaction effect three items at a time on Accounting Equation or a Balance Sheet:

• Cost of Goods (Rs 50,000/-) reduces Asset (stock) of goods by Rs 50,000/-
• Asset (Cash) increases by Rs 55,000/-
• Liability (Owner's capital) increases by Rs 5,000/- because profit increases the owner's capital and loss decreases it.

Hey guys, I hope you understand the concept of Accounting Equation. It is a very interesting topic in accounts and very important also. I will try my best to cover the concept of Accounting Equation, if you have any related queries then please stay tuned in the comment section. Have a nice day, Thanks for reading...