The whole system of accounting has developed from the same basic tenet of a single equation. As a business does not own any thing at its own, so whatever resources, it owns may come from two sources as shown below:
Resources of the business = Sources of resources
Method of Expressing Basic Accounting Equation:
Initially, all the assets may be provided to the business by the owner and some businesses solely rely on owner’s investment. In that case accounting equation may be expressed as:
Assets = Capital
However, as it is usual for the business to borrow amounts from outsiders in addition to owner’s investment so in that case the basic accounting equation may be stated as follows:
Assets = Liabilities + Equity
The equation shows that at any given time the assets of any entity must be equal in monetary terms to the total amount of its liabilities and capital. This also shows that an entity does not own any asset at its own rather these are provided by either of its owner or lenders. The lenders have a claim against the assets of the entity until the liabilities are paid. The owner, therefore, has a claim only on the remaining assets of the entity once lenders are paid off.
Another way of expressing this mathematical relationship involves a simple variation in the equation which shows that difference between what businesses own and what they owe represent owner’s capital.
Equity = Assets – Liabilities
Understanding Terms in Accounting Equation:
In order to understand the relationship between assets, liabilities and capital, it is important to have some basic understanding of these accounting terms.
(1) Assets, Definition and Example:
Assets are monetary or economic resources which are owned by an entity and are expressed to benefit it in future. Moreover they must be quantified and expressed in monetary (dollar) terms.
Some items like company’s outstanding reputation, customers’ loyalty, its popular brands and its skilled and experienced work force etc., though benefit the business but cannot be quantified and expressed in monetary terms. In the absence of any objective monetary value these items are not reported as assets in the accounting records.
Examples of assets include land, buildings, equipment, vehicles, investments, inventory, accounts receivable, cash, etc.
(2) Liabilities, Definition and Example:
Liabilities are obligations of an organization to pay to other entities including individuals, government and financial institutions, or other business. They represent amounts owed to lenders and suppliers. Examples of liabilities include bank overdrafts, loans taken out for the business. Liabilities may also include advances from customers for a future sale or rendering a service in future.
(3) Equity, Definition and Example:
Equity is the investment made by the owner in his business including any accumulated profits and reduced by losses and withdrawals by him. In most cases owner’s capital takes the form of cash or other assets brought by the owner into the business. However, owner may introduce capital by paying a business liability out of his personal account. Similar to liabilities capital is also an obligation of the business to pay to the owner; however business is not obligated to pay the amount of capital in the normal course of events.
(4) Drawings, Definition and Example:
Drawings represent the amounts of business cash or other assets withdrawn by the owner for his personal use. Drawings also occur when business makes payment for owner’s private expenses. In order to avoid unnecessary detail in the owner’s capital balance, a separate record is kept for drawings to include all the withdrawals made by the owner during the year. At the end of accounting period, the total amount in the drawing account is closed and adjusted against the owner’s capital to determine the net value of owner’s investment left within the business after all withdrawals.
Concept of Entity and Accounting Equation:
Under entity concept, a business is considered as a self-contained entity different and separate from its owners or those who are connected with it. This concept asserts that private or personal transactions relating to the business owners must be separated from the business transactions.
This means the only time that the owner’s transactions appear in the accounting records of business when owner gives anything to the business capital; or takes anything out of the business-drawings.
For example, a vehicle bought and paid by a business for office use is treated as a business asset however when a similar type of a vehicle is purchased from business funds for owner’s private use then this is regarded as drawings. Such distinction between the owner’s personal transactions and the business transaction helps accountants in reporting business performance and determining business financial position more objectively and fairly.
The most important aspect of business entity concept in relation with the accounting equation is that the terms “assets”, “liabilities” and capital are defined from the enterprise’s point of view and not from the owner’s view point. This is important as one man’s expense is another’s income and one’s right is another’s obligation. Capital, which represents finances contributed by the owner towards the acquisition of assets of the business, is a liability for the business as long as it retains and uses these assets to sustain its operations. Capital, though an asset for the owner, but business must recognize it as an obligation towards the owner for assets provided.
Concept of Dual Aspect and Accounting Equation:
The concept of dual aspect is a matter of common observation, an everyday give-and-take phenomenon. In financial terms, it means that every transaction has two aspects. Every time a business transaction occurs, it affects the accounting equation in such a way that the equilibrium of assets, liabilities and capital remains intact. This means a change in the amount of total assets is necessarily complemented by an equal change in the total of liabilities and equity (capital).
The equilibrium of accounting equation provides the very foundations on which the whole accounting structure rests. It holds true for all situations, no matter what financial transaction take place. The accounting equation as discussed earlier may be expressed as follows:
Assets = Liabilities + Equity