Accounting Equation is the most important basic to understand accounting. I think if you understand how a transaction moves in the accounting equation, you are able to post any transaction properly. Without having depth understanding of the accounting equation at first, the learning process about accounting should not be ideal. Most importantly, it is pretty easier to get.
But before getting into the accounting equation, we must have some predetermined assumptions so that we can easily get the point of the equation. For instance, the Going Concern assumption is an important assumption where we assume the organization will run for an unforeseeable future.
Another assumption is the Economic Entity Assumption where we think an organization has a separate entity from the owner himself. This assumption will provide us a better understanding.
There are many assumptions but today our topic is the equation. Okay, let’s get to the accounting equation.
The Accounting Equation
Assets = Owner’s Equity (capital) + Liabilities
As you see, there are three elements in the accounting equation. Let’s explain these elements briefly so that you can get the gist of the equation.
Elements of Accounting Equation
As I mentioned earlier, there are elements in the equation. However, the equation can be expanded. Despite being expanded, the equation is based on these three elements. It is very necessary to understand these elements before learning the conditions of the equation.
“An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity” – According to The Conceptual Framework For Financial Reporting 2018
Let’s debunk the sort of complex definition. The definition says an asset requires four conditions to be an asset. These are:
- An asset must be a resource. The resource can be cash, land and buildings, plant and machinery, inventory, furniture, receivables, etc.
- Yes, a resource can be an asset. But the resource must be controlled by the organization. You cannot call another entity’s resource an asset as you don’t have controlling power over that resource. So the second condition is to control the resource.
- A resource controlled by the entity can be an asset but it must be the result of a past event. The resource is obtained by the entity due to a transaction that happened previously.
- The last, not the least important condition is that the asset must have provided future economic benefits to the entity. Without having the capacity to produce future economic benefits, a resource can not be called an asset.
A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. –According to The Conceptual Framework For Financial Reporting 2018
To be a liability, these conditions can be required. Let’s see what these are:
- A liability is something for which the entity is legally bound (an obligation) presently to third parties( outside of the organization). An obligation can be creditors, loans, any sort of payables.
- As like as the assets, it must be happened due to a transaction that happened previously.
- A resource may be obtained due to the obligation, or equity will be diminished.
Owners Capital (Equity)
“any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities” —According to The Conceptual Framework For Financial Reporting 2018
If you convert the definition into an equation, it would be like these:
Equity = Asset – Liability
Equity is basically what the entity is liable to its owners. Owners put their money to earn profit. So the business has an obligation to its owners. It is why when the business earns profit, the equity or owner’s capital increases, or when it loses, the entity’s equity decreases.
Conditions of the Equation
If you understand how these conditions are being applied in the equation, I think you will post any transaction in the equation. And it will be effective afterward in the accounting process. These Conditions are:
- If a transaction increases total assets, total equity or total liability will be increased.
- If a transaction decreases total assets, total equity or total liability will be decreased.
- If a transaction increases one asset, the other asset will be decreased (if the transaction does not have an effect on the liability and equity side)
- If a transaction increases total liability, total equity will be decreased (if the transaction does not have an effect on the asset side)
- If a transaction decreases total liability, total equity will be decreased (if the transaction does not have an effect on the asset side)
Suppose, NafGateway Inc. brought a new computer for $720 cash on 1st July 2021.
Here the important point is that the company bought an asset by spending $720 cash which is also an asset. So Mr. Issac’s one asset decreases and the other increases.
Let’s discuss another example.
NafGateway Inc. paid its debt of $300 to an account payable.
Here, the company paid off its debt. Liability and assets decrease at the same time.
Expanded Accounting Equation
The accounting equation can be broken down further as revenues, expenses, and drawings can be included to understand the equation more clearly.
Asset = Owner’s Capital + Revenues – Expenses – Drawings+ Liabilities
As we have already discussed assets, (owner’s capital) equity, liabilities. Let’s talk about revenues, expenses, and drawings.
Revenues, Expenses, and Drawings
A profitable entity’s main objective is wealth maximization. Therefore, it has to earn revenue by selling goods, rendering services, or by performing any other operational activities.
Revenues increase the owner’s capital as we talked about before that the owners put their capital to expect profit from the business.
Expense, also known as, revenue expenditure is any cost that arises when a business performs any activities to earn profit as well as to help to maintain the earning capacity of an asset. An expense does not result in the acquisition of an asset. Expenses decrease the owner’s capital as they decrease the profit which will be added to equity.
Sometimes, owners may withdraw cash or any other assets from the business. It does result in a decrease in the owner’s capital.
Suppose, Nafgateway Inc. paid his employees salary in $300 cash for a month.
It will create a deduction of assets as well as the owner’s capital as the company paid the expense in cash.
Sometimes, a transaction may not decrease the asset. It may increase the liability and decrease the owner’s capital. For instance, what if the salary has been incurred but not paid. In that circumstance, the salary payable will be created as one kind of liability and the expense will decrease the owner’s capital. So the equation will be equal as liability increases while the owner’s capital decreases.
- Mr. Issac Started his business with $15,000
- The company purchased $1,000 of furniture in cash
- The company purchased machinery on the credit of $2,000
- The company paid salaries in cash for $550
- Mr. Issac withdrew $1000 cash from the company for personal reasons
- The company received $3,000 cash by providing services