Accounting Equation

Accounting Equation

Accounting Equation signifies that the total assets of the company are always equal to the sum of total liabilities and the owner’s capital (in case of company, owner’s Equity). The accounting equation looks like below:

Where,

Assets of the business refer to the economic resources owned by the company that will result in the inflow of cash.

Liabilities are the amount that the organization owes to the outsider.

And capital is the amount invested by the owners into the business.

The above accounting equation represents the relationship among the components of balance sheet that is why it is also referred to as Balance sheet equation where balance sheet is the statement that shows the assets, liabilities and owners capital of the company at the given point of time.

Example

Mr. X started a business of Toy manufacturing for which he invested $50,000 initially on April 1st, 2020 by transferring the amount in the bank account opened for the business. Then on 15th April, Mr. X purchased Toys for resale worth $20,000 ($10,000 by paying cash and remaining $10,000 on credit) and on the same day he bought furniture for office worth $5,000. He sold goods costing $6000 for $8000 to Mr. Y on credit on 16th April, 2020. Other expenses of the business are $1,000 that are incurred and paid in cash on April 16th, 2020.

Now we will analyze the above transaction by passing journal entries for each transaction.

1.       Investment of $50,000.

Since the investment of $50,000 is done by transferring the balance into the bank account. Therefore it increases the capital by $50,000 (Credit capital A/c) and increases the bank balance ( Debit current asset) by $50,000. Journal entry for the same is:

DateParticularsDebit ($)Credit ($)
2020
April
1
Bank A/c50,000
To Capital A/c50,000
(Being Capital
invested by
the owner)

2.       Purchase of Toy:

The purchase of toy initially increases the inventory (debiting the Purchases) by $20,000, decreases the bank balance (Credit current asset) by $10,000 and increases the Trade Payables (Credit current Liabilities) by $10,000. The Journal entry for the same is:

DateParticularsDebit ($)Credit ($)
2020   
April 15Purchases A/c20,000
        To Bank A/c10,000
        To Creditor A/c10,000
 (Being inventory purchased)  

3.       Furniture Purchased:

The purchase of furniture increases the business furniture (debit fixed asset) by $5,000 and decreases the bank balance by $5,000 (credit current asset). The Journal entry for the same is:

DateParticularsDebit ($)Credit ($)
2020   
April
15
Furniture A/c5,000
        To Bank A/c5,000
 (Being furniture
purchased)
  

4.       Sales to Mr. Y

Sales to Mr. Y increase the sales (Credit sales) of the business by $8,000 and also increases the trade receivables account (debit current asset) of the business.

DateParticularsDebit ($)Credit ($)
2020   
April
16
Mr. Y A/c8,000
        To Sales A/c8,000
 (Being sales made
to Mr. Y on credit)
  

5.       Other Expenses Paid:

The expenses paid increases the expenses of the business by 1,000 (Debit expenses) and reduce the bank balance (credit current asset) of the business by 1,000. The Journal entry for the same is:

DateParticularsDebit ($)Credit ($)
2020   
April 16Other Expenses1,000
        To Bank A/c1,000
 (Being other expenses paid)  

             

Now, we will calculate the amount transferred to Capital A/c.

Income Statement

ParticularsAmount ($)
Sales8,000
Total Income [A]8,000
Cost of goods sold6,000
Other Expenses1,000
Total Expenses [B]7,000
Net profit [A-B]1,000
(transferred to capital A/c)

The final value of all the balance sheet items after all the above transactions is:

Calculation of Capital
ParticularsCalculation$
Amount Invested 50,000
Profit transferred 10,000
Total Capital 60,000

Calculation of Assets
ParticularsCalculation$
Bank Balance  
Bank balance at
the beginning 
(Capital investment)
50,000 
Less:
Purchase of inventory
-10,000  
Less:
Purchase of furniture
-5,000 
Less:
Expenses Paid
-1,00034,000
   
Furniture 5,000
   
Debtor (MR. Y) 8,000
   
Inventory  
Inventory purchased20,000 
Less:  COGS6,00014,000
   
Total Assets 61,000
   

Calculation of Liabilities
ParticularsCalculation$
Trade Payables 10,000
Total Liability 10,000

Now sum of total liabilities and capital = $51,000 + $10,000 = $61,000

Total Assets = $61,000

Therefore, Total Assets = Liabilities + Capital

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