The accounting equation
The accounting equation is an equation that shows the relationship between a business’ assets, liabilities and stockholder’s equity. The equation is represented below;
Assets =Liabilities + owners Equity
The assets represent the resources owned and controlled by the business for the purpose of getting future benefits. The assets are further classified as fixed assets, current assets and non-current assets. Fixed assets includes land, buildings, fixtures, and fittings. A current asset entails cash, accounts receivables, inventories, and deposits. The company’s assets are commonly acquired through debt or equity financing as shown by the accounting equation; Assets=Liabilities + owners equity
For example, if a trader starts a new business he/she will either buy the assets with borrowed money which is a liability or money received from different investors that bring about the equities.
Liabilities represent a business obligation to other people. The duty includes future payment of money, provision of service, delivering of goods and all other past transactions with economic value. Those liabilities whose requirements can be met within a period of one year are classified as short-term liabilities while liabilities that cannot be paid within a period of one year are the long-term liabilities. Examples of short-term liabilities include the following; accounts payable, salaries payable, tax payable among others. The Non-current Liabilities examples are; long-term loan, long-term bonds payable and notes payable.
Liabilities = Owners Equity –Assets
Owners’ Equity represents the residual amount that the business owner takes home after the business meeting its debt obligation. The owners’ equity equals the total assets minus the liabilities.
Owners Equity=Total assets –Total liabilities
The owner’s equity can be affected by drawings by the owner, additional investment, and net profit/loss.
Relationship between accounting equation and components of the balance sheet
The accounting equation states that the statement of affairs is balanced since all the assets can either be bought by the owner’s money or borrowings from other people, liabilities. In the balance sheet, the assets are recorded on the debit side while liabilities are usually recorded on the credit side of the statement of affairs. The total components of the balance sheet on the credit side should always equal to the total parts on the debit side. As shown by the accounting equation, this brings about the relationship between the accounting equation and the balance sheet components.
Components of the accounting equation effect on each other examples
The components of the equation affect each other in the following ways;
Assets =Liabilities + owners Equity
Liabilities = Assets- Owners Equity
Owners Equity=Assets- Liabilities
Suppose a business has a total Assets of $100,000 and the total liabilities as $25,000 then the Owners equity=A-L
C=100,000-25,000
= $75,000
L= A- C
L=10,000 - 75,000
L= $25,000
A= L+ C
A=25,000+75,000
= $100,000
Effect of transactions on accounting equation
A business transaction that increases the total assets always increases the total liabilities and the Owners’ Equity. A transaction that decreases the total assets reduces the total liabilities and the Owners’ Equity. Some transaction may only increase the assets and reduce the liabilities.
For example if a trader starts a new business with the following transactions
i) The trader deposits $25,000 in his checking account for the purpose of business
The effect is, cash as an asset increases by $25,000 and the owners worth in the company is $25,000
ii) The trader purchases a machinery using cash for $300,00
Machinery as an asset increases by $300,000 the traders cash also decreases by $300,000
iii) The trader purchases an office space worth $150, 000 and pays $30,000 cash and the rest to be paid in future.
The office space increases by $150,000 and the cash decreases by $30,000.The business liabilities increase by $120,000.
Transactions such as drawings, expenses, and revenues also change the component of the accounting equation. For example if,
i) The trader made cash sales worth $20,000
The business revenues increase by $20,000 .owners equity also increases by
$20,000
ii) The Trader withdraws $50,000 for personal use
Cash will increases by $50,000 and the owners’ equity decreased by $50,000
iii) The trader pays for electricity for $ 10,000
Cash decreases by $10,000 and the expense decrease the owners’ equity by $10,000.
References
Kieso, D., Weygandt, J., & Warfield, T. (2012). Intermediate accounting. Hoboken, NJ: Wiley.
