Accounting Equation
The accounting equation reflects the fact that businesses own assets that are either financed by the capital invested from its owner, or loan, taken from the creditors. Hence, total assets owned by a business are always equal to the amount the business owes to its investors (Owner and Lenders).
At any given point in time, total assets will equal the total of capital and liability and the equation remains balanced. This very simple idea is called Accounting Equation and is considered the backbone of accounting and bookkeeping.
Explaining Accounting Equation
The different monetary resources (e.g. Property, land, vehicles, plant, machinery e.t.c) that are used by businesses are called assets. The amount of resources provided by the owner to finance these assets is called capital. This means that when the owner provides all the money to purchase the asset, the accounting equation can be expressed as:
Assets= capital
It can be seen that the value for both sides of the equation is the same. This is because we are dealing with the same thing from two different perspectives – the value of the investment in the business (Capital) and the value of the owners’ ownership (Assets).
In general, however, people other than the owner may also have financed some assets. Liability is the name given to these people and because of the amount owed for these assets, the accounting equation has now changed:
Assets=Capital + Liabilities
It is a fact that no matter how you present the accounting equation, the sum of the two sides will always be equal to each other, and this will always be a true irrespective number of transactions. Actual assets, capital, and liabilities may vary, but the total amount of assets will always be equal to the total of capital + liabilities.
Another perspective that can be derived from the accounting equation is that a slight change in its representation provides;
- the actual worth of the owner’s stake/ the Net worth of the business.
The Net Worth of the business (Net Assets) will always be equal to the assets of the business minus liabilities.
Net Assets (Capital) = Assets-Liabilities
To enhance your understanding and applications of the accounting equation, it is advised that you first go through this worked-out example before reading any further.
DOUBLE ENTRY SYSTEM FOR RECORDING REVENUE & EXPENSES
What is the double entry for revenue and expenses?
In a double-entry system, both revenue and expense are recorded as capital. This means upon earning revenue a Credit entry, whereas when costs are incurred a Debit entry is recorded.
Profit is the amount by which revenues exceed the costs. The term revenue refers to the sales value of goods and services that are sold to customers. Whereas, Expenses mean the cost of all assets that have been consumed to obtain these revenues. On the other hand, our costs may exceed revenue for a period. In this case, we have incurred a loss.
Excess revenue over the expense in a period results in profit. Profit belongs to owners, who contributed capital. Therefore, it is only reasonable to treat revenue the same as capital (Credit when revenue earned). Similarly, further Revenue and Expense have been well-defined in the previous chapters and both revenue and expenses eventually result in profit (increase) and loss (decrease) effect on capital account.
The rules of debit and Credit can now be further enhanced to include the entries of revenue and expenses.
Note: At this stage, it is advised that practice as many questions as possible. Having a strong grip over the accounting entries will strengthen your core knowledge of accounting.
Profit and loss are the result of a specific period and are transferred to the capital after the end of the accounting period. The frequency of calculation of profit and loss depends upon the organization and usually for larger organizations it is calculated more frequently.
To calculate profit and loss, closing balances of all types of expense and revenue accounts are transferred to a single account (i.e. Profit and Loss Account). All expenses are posted on the debit side, whereas revenues are posted on the Credit side of this account. If credit balance exceeds debit balance, this implies that businesses have earned a profit during the period. However, if the total debit side exceeds the total credit side, this means the business has suffered the loss.
In business, a separate account for each type of expense and revenue is kept. Accounts are named and organized in a fashion that each type of transaction can easily be related and recorded into these accounts.
