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Introduction to Accounting Equation

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  • Last Updated : 02 Jun, 2022

Business is run through transactions. Transactions are financial in nature and they affect the financial position of any business. Every transaction increases or decreases Assets, Liabilities, or Capital. The accounting process revolves around these three terms i.e., Assets, Liabilities, and Capital. The entire accounting structure is based on these three items. A business receives its fund from proprietors & creditors and invests those funds to acquire assets. This shows that the amount of capital and liabilities will be equal to the total amount of assets. This can be shown by using any of the equations listed below:

  • Assets = Liabilities + Capital
  • Liabilities = Assets – Capital
  • Capital = Assets – Liabilities

The above relationship is known as ‘Accounting Equation’ or ‘Balance Sheet Equation”. Let us discuss these three elements one by one:

1. Assets:

Assets can be described as the value of the things owned by the firm for the purpose of using them in the business. They are not meant for sale. Expenditure that occurred in acquiring these valuable articles is also considered as asset.  Assets can be of different types I.e. Fixed, Floating, Fictitious, Intangible, and Liquid. Assets are purchased to increase the earning capacity of the business. The value of these assets keeps on changing from time to time.

Some of the assets are as follows: Cash in Hand, Cash at Bank, Sundry Debtors, Bills Receivables, Investments, Plant & Machinery, Equipment and Tools, Furniture and Fittings, Closing Stock, Prepaid Expenses, Accrued Income, Etc. 

2. Liabilities: 

Liability can be described as any claim of outsiders against the business or against the assets of the business. It is the amount that the firm is liable to pay to the outside party. The proprietor’s claim against the business is termed as an internal liability.  External liabilities are of three types:

  • Creditors for Goods- Sundry Creditors and Bills Payable.
  • Creditors for Expenses– Outstanding Salaries, Unpaid Wages, Rent Due.
  • Other Liabilities- Bank Loan, Bank Overdraft, Partner’s Loan, Etc. 

The value of liabilities also keeps on changing from time to time. An increase in the value of liabilities means that the firm has to pay more and a decrease in the value suggests that the firm has to pay less.

3. Capital: 

The amount invested by owners in the business whether in cash or kind is called capital. The Owner of the business can be a single person in a sole proprietorship, two or more than two in partnership, and many as shareholders in a company. Capital can also be described as the owner’s claim against the assets of the business or the Owner’s Fund. It can be further enumerated as under:

  • Capital
  • Reserve, General Reserve, or Reserve Fund
  • Profit or Retained Earning and
  • Interest on Capital

The interrelationship between assets, liabilities, and capital results in the transactions that show that a change in one element forces a change in another. Let us understand this with some examples:

Transaction 1:  Nupur started a business with cash Rs. 20,000.

Ans: Here, the two accounts affected are-  

Cash -> Assets-> Increase -> Rs. 20000

Capital -> Capital-> Increase -> Rs. 20000

Transaction 2: Purchase of goods worth Rs. 50000 on credit.

Ans: Here, the two accounts affected are-

Stock -> Assets -> Increase -> Rs. 50000

Creditors -> Liabilities -> Increase -> Rs. 50000

These will affect the accounting equation as follows:

 

Rule of Debit and Credit ( Under Modern Approach):

Under the Modern approach, all the accounts are classified into the following five categories mentioned below:

1. Assets Account: An increase in the amount of any asset is recorded on the debit side of the assets account whereas any decrease in the amount of an asset will be recorded on the credit side of the asset account.

2. Liabilities Account: When there is an increase in any of the liabilities, it is recorded on the credit side of that particular liability and when there is a decrease in the liability, it is recorded on the debit side of the liabilities account. 

3. Capital Account: An increase in the capital is recorded on the credit side and the decrease in the capital is recorded on the debit side.

4. Revenue or Income Account: All increases in the gains and incomes will be recorded on the credit side as it leads to an increase in capital and all decreases in the gains and income will be debited in that particular account as it reduces capital. 

5. Losses or Expenses Account: All increases in the losses and expenses are recorded on the debit side and all decreases in the losses and expenses will be recorded on the credit side.

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