Definition and Explanation: The three basic elements of accounting are assets, liabilities and owners' equity (capital). The assets represent the things of value that a business owns. The liabilities are the claims of the creditors against those assets. The owner's equity (capital) is the claim of the owner against those assets. Whatever is not claimed by the creditors belongs to the owner. As a result, the total claims against the assets are always equal to the total assets. This equality between the assets and the liabilities and the owner's equity is expressed by the "accounting equation".
Assets = Liabilities + Owner's Equity The two sides of the accounting equation must always be equal because the rights, to all the assets of a business are owned by someone. The creditors have a claim against the assets of a business until the liabilities have been paid. The owner has a claim against the remaining assets of the business. If no liabilities exist, then the owners' equity will equal to the total assets. A clear understanding of the accounting equation is essential, because most of accounting systems based on it. The equation actually identifies the claims (or rights) against the assets held by a business. The two sides represent different versions of the same thing. The left side of the equation, assets, consists of the "resources" (properties) held by the business; the right side of the equation, equities (creditor's claim and owner's claim against the assets) consists of the "sources". Resources: what they are = Sources: who supplied them Assets = Claims against assets "The expression of the equality of an entity's assets with the claims against them is referred to as the accounting equation." It should be remembered that the two sides of the equation are always equal because these two sides are merely two views of the same business resources. The assets side shows us "what resources" the business owns, the other side (liabilities and owner's equity) tells us "who supplied these resources" to the business and how much each group supplied. Effect of Business Transactions: Recall that every business transaction brings about a double change in the financial position of the business. The financial position of a business is represented by the accounting equation: Assets = Liabilities + Owner's Equity Regardless of whether a business grows or contracts this equality between the assets and the claims against the assets is always maintained. Any increase in the amount of total assets is necessarily accompanied by an equal increase on the other side of the equation, that is, by an increase in either the liabilities or the owner's equity. Any decrease in the amount of total assets is necessarily accompanied by an equal decrease in liabilities or owner's equity. Any expense incurred will decrease the owner's equity on one side and decrease cash on the other side of the equation. Any revenue earned will increase the owner's equity on one side and increase assets on the other side. The effect of transactions upon the accounting equation can best be illustrated by taking a brand-new business as an example: Example: Assume that Mr. Naveed decided to start a "shoes business" of his own, to be known as Naveed Shoes Company". The new business was started on 1st January, 2005, when Mr. Naveed invested $5,00,000 in his business. Recall that the business entity is kept separate from its owner. The business unit has borrowed $5,00,000 from its owner. This is a first transaction of the business. It brought a double change in the financial position of the business — an asset (cash) increased by $5,00,000 and a liability (owner's equity or capital) increased also by $5,00,000. In other words, this transaction is consisting of two elements:
Assets = Liabilities + Owner's equity --------------------------------------------- --------------------------------------------------------------------------------- Cash = Capital $500,000 = Nil + $500.000 __________________________ ______________________________________________ Transaction No. 2: Mr. Naveed purchased a building for $2,00,000. This transaction brought two changes—cash (asset) decreased by $2,00,000 and Building (a new asset) increased by $2,00,000. Now the equation will be; Assets = Liabilities + Owner's equity --------------------------------------------- --------------------------------------------------------------------------------- Cash + Building = Capital $300,000 + 200.00 = Nil + $500.000 __________________________ ______________________________________________ Transaction No. 3: He purchased furniture for $30,000. This transaction brought two changes—cash (asset) decreased by $30,000 and furniture (a new asset) increased by $30,000. The equation will be; Assets = Liabilities + Owner's equity ___________________________________ ________________________________________________ Cash + Building + Furniture = Capital 270,000 + 200.000 + 30.000 = Nil + $500.000 Again there is no change on the right side of the equation and cash (asset) is converted into a new asset, furniture. It may be noted that equality of the two sides was maintained throughout the recording of the transactions. |