Accounting Equation | Meaning | Advantages | Format of Accounting Equation

 

Accounting Equation | Meaning of Accounting Equation | Advantages  of Accounting Equation | Format of Accounting Equation

 

Meaning of Accounting Equation

Accounting equation is the mathematical expression of accounting terms.

In mathematics equation expresses, left hand side value must be equal to right hand side; so as on accounting equation assets must be equal to liabilities.

Accounting equation is not an account or statement; it is just a rough work or working note of financial statement.

In some countries, it is prepared to check accuracy before preparing financial statement.

 

The expression of this equality in-terms-of equation is known as accounting equation.

An accounting equation is expressed as under:

          Resources       = sources of finance viz capital and liabilities

          Resource         = assets

Therefore, according to balance sheet the above equation can be expressed in the following ways:

  

 

Definition of accounting equation “Accounting equation is a mathematical expression used to describe the relationship between the assets, liabilities and owner’s equity of the business.”

  

 

Assets	= Liabilities
Assets	= Liabilities	+ Capital
Assets	= Liabilities	+ Capital + Revenue – Expenses – Drawings

 

 

(1) Extracted list of assets

Current assets

Cash, bank

Stock (inventory, merchandise),

Stock (opening stock, purchase, sales, closing stock)

Debtor (customers, bills receivable, account receivable),

Prepaid expenses, advance expenses

 

Fixed assets

Land, building, furniture, plant, machinery, equipment, vehicle etc

 

Investment

Investment, investment in shares, investment in debentures

Fixed deposit

 

(2) Extracted liabilities

Current liabilities   

Creditor (suppliers, bills payable, account payable)

Outstanding expenses, advance income

Bank overdraft

 

Long-term liabilities  

Bank loan, debenture

 

 

(3) Extracted income

Commission received, discount received, interest received, rent received, dividend received etc. 

 

(4) Extracted expenses

Salary, rent, commission paid, discount allowed, interest, insurance, dividend paid, utility expenses etc.

 

 

(5) Capital or Owner’s equity

Capital is also known as owner’s equity, shareholders’ equity as per requirement

Incomes are added with capital

Expenses are deducted from the capital

 

Keep in mind

Owner’s equity is also known capital or shareholders’ equity. Owner’s equity is the capital amount of sole proprietor and partners invested in the business. Shareholders’ equity is the capital amount of private limited company and limited company. Expenses, income, profit or loss is the part of capital (owner’s equity); they must adjust with capital. Income and profit are added with capital (owner’s equity). Expense and loss are deducted from capital (owner’s equity).

 

Assets, capital and liabilities are three basic elements of every business.

The relationship between these three elements remains unchanged.

Change in one element also changes other element.

Increase in assets side with equivalent increase in capital or liabilities.

Decrease in assets with equivalent decrease in capital or liabilities.

 

 

 

In short, the rules of debit and credit are:

Assets, expenses and drawings	=	Increase ­ Debit	Decrease ¯ Credit
Liability, capital and revenue	=	Increase ­ Credit	Decrease ¯ Debit

 

 

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Click on link for YouTube videos topic wise :
Accounting Equation	http://tiny.cc/c89jkz
Basic Journal Entries in Nepali	http://tiny.cc/uaakkz
Basic Journal Entries	http://tiny.cc/8aakkz
Journal Entry and Ledger	http://tiny.cc/caakkz
Ledger Account	http://tiny.cc/haakkz
Subsidiary Book	http://tiny.cc/399jkz
Cash Book	http://tiny.cc/889jkz
Trial Balance and Adjusted Trial Balance	http://tiny.cc/c59jkz
Bank Reconciliation Statement (BRS)	http://tiny.cc/q59jkz
Depreciation	http://tiny.cc/ugakkz
Click on link for YouTube videos chapter wise:
Financial Accounting and Analysis (All videos)	http://tiny.cc/jlersz
Accounting Process	http://tiny.cc/mlersz
Accounting for Long Lived Assets	http://tiny.cc/plersz
Analysis of Financial Statement	http://tiny.cc/slersz

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Advantages of Accounting Equation

The main advantages of accounting equation are as follows:

It shows owner’s equity, liabilities and assets.

It shows the effect of each transaction on owner’s equity, liability and assets.

The accounting equation can give a clear picture of business’s financial situation.

It is prepared to calculate the accounting equation to read balance sheet.

Accounting equation helps to analyze financial position of the business without preparing financial statement.

When accounting equation is presented in item wise, it helps to calculate various ratios like capital to total assets, liability to total assets, current assets to fixed assets, current liability to current assets etc.

Ratios help to take important decisions like success or failure of a business.

If owner’s equity decreases, it implies failure and vice versa.

 

 

Format of Accounting Equation

Assets, capital and liabilities are three basic elements of every business.

The relationship between these three elements remains unchanged.

Change in one element also changes other element.

Increase in assets side with equivalent increase in capital or liabilities.

Decrease in assets with equivalent decrease in capital or liabilities.

 

 

PROCEDURE FOR ACCOUNTING EQUATION

These steps are required for developing accounting equation:

Step 1:      Find out assets, capital or liabilities from transaction.

Step 2:      Find out increase or decrease (debit or credit, add or less) in assets, capital or liabilities.

Step 3:      Show the effect on equation.

Accounting Equation

Particulars	Assets		=	Capital		+	Liabilities
Business started with cash,	xxxxx	cash/bank	=	xxxxx		+	0
bank stock and assets	xxxxx	stock
	xxxxx	assets
Beginning equation	xxxxx		=	xxxxx		+	0
Goods purchased in cash	− xxxx	cash		0			0
	+ xxxx	stock
New equation	xxxxx		=	xxxxx		+	0
Goods purchased on credit	+ xxxx	stock		0			xxxxx	creditor
New equation	xxxxx		=	xxxxx		+	xxxxx
Goods sold in cash	+ xxxx	cash		0			0
	− xxxx	stock
New equation	xxxxx		=	xxxxx		+	xxxxx
Goods sold on credit	+ xxxx	debtors		0			0
	‒ xxxx	stock
New equation	xxxxx		=	xxxxx		+	xxxxx
Assets purchased	+ xxxx	assets		0			0
	‒ xxxx	cash
New equation	xxxxx		=	xxxx		+	xxxxx
Goods sold at profit or loss	+xxxx	cash		+ xxx	profit
	‒ xxxx	stock		‒ xxx	loss
New equation	xxxxx		=	xxxxx		+	xxxxx
Asset sold at profit or loss	+xxxx	cash		+ xxx	profit
	‒ xxxx	asset		‒ xxx	loss
New equation	xxxxx		=	xxxxx		+	xxxxx
Expenses paid	-xxxx	cash		-xxxx	expenses
New equation	xxxxx		=	xxxxx		+	xxxxx
Income received	+xxxx	cash		+xxxx	income
New equation	xxxxx		=	xxxxx		+	xxxxx
Prepaid expenses paid	+xxxx	adv	=	0		+	0
	‒ xxxx	cash
New equation	xxxxx		=	xxxxx		+	xxxxx
Outstanding expenses	0		=	‒ xxxx	exp	+	xxxx	O/s
New equation	xxxxx		=	xxxxx		+	xxxxx
Loss by fire and insurance claim	+ xxxx	claim	=	‒ xxxx	loss	+	0
	‒ xxxx	stock
New equation	xxxxx		=	xxxxx		+	xxxxx
Accrued income	+ xxxx	receivable		+ xxxx	income		0
New equation	xxxxx		=	xxxxx		+	xxxxx
Drawings	‒ xxxx*	cash/bank		‒ xxxx*			0
	‒ xxxx*	stock
New equation	xxxxx		=	xxxxx		+	xxxxx
Advance income received	+ xxxx	cash	=	0			xxxx	adv
New equation	xxxxx		=	xxxxx		+	xxxxx
Cash paid to creditors	‒xxxx	cash		+ xxxx	discount		‒ xxxx	B/P
New equation	xxxxx		=	xxxxx		+	0
Cash received from debtors	+xxxx	cash	=	‒ xxx	discount		0
	‒ xxxx	debtor
Final equation	xxxxx		=	xxxxx		+	0

 

 

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