The Accounting Equation describes what actually are the resources that are applied in the Business & who supplied those resources (where have they come from).
Resources Available to Run a Business = Where these Resources Come from or who made them available
Accounting Equation: Assets = Capital + Liabilities
Explanation of Accounting Equation
How well you understand the accounting equation will pave the way to how well you are going to understand the double entry transactions, ledgers, trial balance & financial statements. This equation tells you about the financial position of a business at the moment. The double entry system of accounting is based on the above accounting equation or you can say it is rather the very foundation of double entry accounting transactions. You have seen the Assets at the left hand side of the Accounting equation above, so lets discuss the Assets in detail.
Assets are all the economic resources made available in the business to carry out its operations.
Examples of Assets:
Land & Buildings, Business Premises, Vehicles, Furniture & Fixtures, Computers, Equipments, Tools, Cash, Inventory are all examples of typical assets that we usually find in most of the businesses.
More Details ~ Assets
The items that you put in the business as a resource could be Tangible or Intangible.
Tangible assets have physical existence whereas intangible assets do not have physical existence but they do have economic value attached with them. Examples of tangible assets include factory building, office premises, furniture & fixtures, tools & equipments, Cash in hand, cash at bank, merchandise inventory etc.
The intangible assets are those assets that have value but do not have physical existence. For example copyright, patents & trademarks, goodwill etc.
Asset in Accounting Equation (The Left Side of Accounting Equation)
To run a business one need to put in some resources for example it requires a premises with all the necessary items, cash and other items with economic value. These are the Assets that are applied in the business irrespective of whether you owns them or you do not own them. You see these assets in the left side of accounting equation. The balance sheet of a business shows all the assets at a specified time and that equals to the capital and liabilities of a business.
ASSETS are the Resources in Business = CAPITAL & LIABILITIES are from where assets are acquired
Capital & Liabilities (The Right Side of Accounting Equation)
The Accounting Equation states that the Assets are always equal to the sum of Capital & Liabilities. This means that all the resources of economic value that a business has, comes from the investment made by the owners. That investment can be their own, and that is called owner’s equity or capital. If the investment made in the business is also acquired from loan then that would be a liability.
Either of these can be possible
Assets Acquired from Capital (Equity)
Assets Acquired from Loans (Liability)
Assets Acquired from Capital & Liability both
Capital: Capital is what a business owns or you can also call it owners equity. It is the investment made available by the owners from their own funds. The net worth of a business is the owners equity or capital.
You can twist the Accounting equation a little bit to have a better idea of “how the capital looks like”.
So recalling the Accounting Equation, it is
Assets = Capital + Liabilities
Capital = Assets – Liabilities
This form of accounting equation simply says that the Capital can be arrived at by subtracting all the Liabilities from the total Assets. The Capital is increased or decreased by further investments or by the net profits or net losses while the business operates.
Liabilities are the obligations or debts of a business, that is what a business owes to the “non-owners”.
ILLUSTRATION OF ACCOUNTING EQUATION
Let’s recall what the accounting equation says
ASSETS = CAPITAL + LIABILITIES
Consider that you are Starting a trading business and for that you require a total amount of $10,000. In this case you have that amount from your personal resources to invest in the business & you do not require any loans.
So the scenario is, you invested Cash $100,000 from your own resources to start a business. This also means that you have put aside $100,000 for your business.
It will look like,
Assets = Capital + Liabilities
Cash in Hand $100,000 = Investment $100,000 + no liability $0
So, the above equation tells that the resources you applied in your business is $100,000 cash which is the left side of the equation and the right side of the equation is telling that where have you got this Cash, the answer is you invested it, and it is the capital of your business now.
With $100,000 cash as asset in your business you can buy an office premises, furniture, equipment and some merchandise to sell. See how you can apply these things in the accounting equation;
So, as you can see that the assets remain equal to the capital invested in the business or you can say that the left side of the accounting equation is equal to the right side of the accounting equation. Here it was worth noting that nothing was yet borrowed in the business that is why the liability is shown ‘NIL’.
Now you can simply change your business scenario a little bit. Lets say you invested $70,000 from your own and taken loan of $30,000 from somewhere. All other things same as in the case 1, we can see how the accounting equation is absorbing these things.
Assets = Capital + Liabilities
Cash in Hand $100,000 = Own Investment $70,000 + Bank Loan $30,000
The above illustrations are based on the point where you have started your business. As you start your operations and begin trading activities you open various assets accounts, debtors and creditors account and many others and whenever at any point of time you will compare your assets total to capital & liabilities total, they will always come equal.
For Case 3 you may start up your business without introducing your own capital but taking loan from a bank. In that way your assets will be equal to the liabilities.
The Accounting Equation is all what you see in your balance sheet. The net profit or loss that occurs in your business and that you will calculate in profit & loss account will affect the capital account of balance sheet. You will study different titles associated with Capital Accounts like for instance Retained Earning Account in financial statements tutorials.
Study Outcomes of Accounting Equation Tutorial
After reading the Accounting Equation Explanation & illustrations, the accounting students could understand and answer to:
What is Accounting Equation?
What is the difference between assets, liabilities & capital?
Scenario based understanding of Accounting Equation.
How is Accounting Equation related to Balance Sheet?