Special terms are used when describing something in accounting. When resources put into business by the owner are called Capital or Owner Equity. Actual economic resources owned by the business are called assets. Owner supplied the resources, the accounting equation will be:
Capital = Assets
Besides the owner some other people supplied the assets are called liabilities. A liability is the amount owing to those who supplied assets to the business. Now the accounting equation will be shown
Capital = Assets – Liabilities
Both sides of the equation will have the same total, because we are treating with the same thing with two different ways. It is simply, the value investment by owner in the business and the value owned by the owners.
This accounting equation is not presenting business resources at a glance. If change the equation and switch assets and Capital or Owner Equality around. It will give the substitute equation for the above one.
Assets = Capital/O.E + Liabilities
This equation can be described as:
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(Assets) Resources in the business
-
(Capital + Liabilities) Resources supplied in the business by owners and others people
No matter how we present and how many transactions incurred the accounting equation both sides of the equation will remain the same all the time.
Assets consist of vehicle, machinery, building, stock, property, debts owed by customers, money in the bank account.
Liabilities consist of all amounts payable to suppliers for goods and services provided and all those expenses incurred but still not paid for. It also includes funds borrowed by the business.
Capital is also called Owner Equity. It consists of funds invested in the business plus profit if retained minus any share of profit paid to the business owner.
Some examples of accounting equation will better understand this concept
Mr. Umar Farooq started a new business, with the name of “Umar Cloths”. The new business was started on 1st July, 2010, when Mr. Umar invested $100,000 in his business. Business entity will be kept separate from its owner.
Accounting Equation – Transaction No. 1
Mr. Umar invested $100,000 in his business and this will be the first transaction of the business. It will affect both the business and owner. Cash Increased by $100,000 as well as capital/Owner Equity increased $100,000. The Transaction will be:
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Assets |
= |
Liabilities |
+ |
Owner’s equity |
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Cash |
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|
|
Capital |
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$100,000 |
= |
Nil |
+ |
$100,000 |
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Accounting Equation – Transaction No. 2
A separate building is required for the new business Mr. Umar decided to purchase a building for $10,000. After this transaction, two changes occurred in the accounting equation, cash decreased by $10,000 and a new Building recorded as asset, increased by $10,000. The changes incurred will affect only the asset side of the accounting equation, cash converted into building. Other side to the equation remained unchanged. Equation will be
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Assets |
= |
Liabilities |
+ |
Owner’s equity |
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Cash |
+ |
Building |
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Capital |
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$90,000 |
+ |
$10,000 |
= |
Nil |
+ |
$100,000 |
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Accounting Equation – Transaction No. 3
A Pickup (vehicle) purchased for the business for $15,000. Again cash converted into vehicle. The transaction will be:
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Assets |
= |
Liabilities |
+ |
Owner’s equity |
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Cash |
+ |
Building |
+ |
Vehicle |
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Capital |
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$75,000 |
+ |
$10,000 |
+ |
$15,000 |
= |
Nil |
+ |
$100.000 |
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Accounting Equation – Transaction No. 4
Mr. Umar purchased goods (Clothes) for $20,000 on credit. In this transaction two changes incurred, asset side of the accounting equation (stock) increased and a liability is created on the other side of the accounting equation.
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Assets |
= |
Liabilities |
+ |
Owner’s equity |
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Cash |
Building |
+ |
Vehicle |
+ |
Goods |
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Creditors |
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Capital |
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$75,000 |
$10,000 |
+ |
$15,000 |
+ |
$20,000 |
= |
$20,000 |
+ |
$100.000 |
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Accounting Equation – Transaction No. 5
The business sold goods, cost of goods sold is $12,000 for $15,000 for cash, out of cash $10,000 paid to creditors. Four changes incurred in the accounting equation, first cash increased by ($15,000-$10,000 paid to creditors/accounts payable = $5,000 cash increased); secondly goods decreased by $12,000; thirdly difference between sales price and cost price is profit which is $3,000, owner equity increased by $3,000. Fourthly liability decreased by $10,000. The equation will be:
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Assets |
= |
Liabilities |
+ |
Owner’s equity |
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Cash |
+ |
Building |
+ |
Vehicle |
+ |
Goods |
= |
Creditors |
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Capital |
|
$75,000 |
+ |
$10,000 |
+ |
$15,000 |
+ |
$20,000 |
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$20,000 |
+ |
$100,000 |
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+$5,000 |
– |
$12,000 |
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– $ 10,000 |
+ |
$3,000 |
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$80,000 |
+ |
$10,000 |
+ |
$15,000 |
+ |
$8,000 |
= |
$10,000 |
+ |
$103,000 |
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Accounting Equation – Transaction No. 6
Another transaction incurred as the business sold goods, cost of goods sold $4,000 for $6,000 on credit/receivable. After this transaction, firstly the stock reduced by $4,000, secondly (debtor/account receivable) account is created and increased by $6,000, thirdly the capital/O.E increased by $2,000 as the profit earned by the business. The equation will be:
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Assets |
= |
Liabilities + Owner’s equity |
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Cash |
+ |
Building |
+ |
Vehicle |
+ |
Goods |
+ |
Debtors |
= |
Creditors |
+ |
Capital |
|
|
$80,000 |
+ |
$10,000 |
+ |
$15,000 |
+ |
$8,000 |
+ |
Nil |
= |
$10,000 |
+ |
$103,000 |
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|
– |
$4,000 |
+ |
$6,000 |
= |
+ |
$2,000 |
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$80,000 |
+ |
$10,000 |
+ |
$15,000 |
+ |
$4,000 |
+ |
$6,000 |
= |
$10,000 |
+ |
$105,000 |
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