What is the accounting equation? The accounting equation equates Capital is equal to Assets minus Liabilities. If we put it in the form of an equation it will be as
Capital = Assets - Liabilities.
This forms the basis of all accounting and the double-entry system works around it and the business transaction are recorded in the books of accounts accordingly. This recording of double-entry in the books of accounts is commonly known as Book Keeping. Before we move on to that how the double-entry system works we need to understand the meaning of the above terms.
CAPITAL: It is also known as Share Holder Equity or Owners Equity. The objective is to finance or invest in a company or a business concern for its overall operation and growth. Capital normally comprised of 1) Owner's equity and 2) Debt equity. Owner's equity is the capital that is initially invested in the company and the investor owns the company whereas debt refers to the loan and other credits and that need to be repaid in future operations of the company in the form of interest.
ASSETS: Property owned by a business having value and worth is known as a business asset of the company. Business assets can be grouped as
> Fixed assets: can be used for a longer period and it is intended to produce further goods and semifinished goods. It covers property, plant, and machinery, equipment, furniture and fixtures, vehicles, and transport. It can not be converted into cash immediately.
> Current assets: It can be converted into cash immediately and it covers inventories, cash, bank cheques, receivables, short term deposits, marketable securities, stocks, prepaid expenses, and short term investments.
> Tangible assets: All the fixed assets and current assets can be grouped under tangible assets.
> Intangible assets: It covers all the intellectual property, goodwill, copyrights, trademarks, designs, patents, brands, franchises, licenses, trade secrets, and reputation.
LIABILITIES: Business liability represents the debts of the firm or company. Business borrowings create business liabilities. It covers bank borrowing, short-term loans, overdrafts, supplier credit, credit purchases, and mortgages all represent business liabilities. All the business payables are business liabilities. Business expenses also create liabilities like taxes payable, salaries payable, and bills payable. It can be grouped in balance under Long term liabilities and Current Liabilities.
The above equation must remain in balance and it represents all the items of the balance sheet. To keep it in a balanced position a system has been devised know as Double Entry Bookkeeping. Business transactions are recorded through journal entries having a minimum double impact to maintain the balance. For example, initial cash investment is made in a company it will increase the shareholder equity (Capital) on one hand and an increase in the asset (cash) on the other hand.
Capital = Assets - Liabilities
Shareholder Equity = Cash - with no change in the liabilities
10,000 = 10,000 - 0
10,000 = 10,000 The equation is balance because of the double impacts of the transaction.
These double impacts of the transaction are known in accounting parlance as "Debit" and "Credits". Before going into that how debit and credit affect the accounting equation, we need to discuss two major accounts: Revenues and Expenses. It can be best explained by given examples. Suppose a company provide a service of Rs 15,000 and gets cash
Capital = Assets - Liabilities
Equity = Cash - No change in liabilities
15,000 = 15,000 - 0 The equation is balanced again with no impact on the liabilities. If the company does not get the cash the equation will be
Equity = Receivables - No change in liabilities
15,000 = 15,000 - 0
Here the revenue is directly taken as an increase in equity and similar expenses are taken as a decrease in equity. For this income statement is drawn showing revenues and expenses and we shall discuss it in detail when discussing financial statements.
How the Debit and Credit affect the accounting equation....is explained as under
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