Accounting Equation

There are three basic foundations of accounting upon which the whole accounting is based i.e.,
Assets, Liabilities and Capital. Assets in business are financed by capital and liabilities so assets
are always equal to capital plus liabilities by following the “Dual Aspect Concept of
Accounting”. Dual aspect concept of accounting states that “for every debit there is a credit”
which means that debit(s) of particular transaction is equal to credit(s) of that particular
transaction. Normal balance of assets is debit while normal balance of liabilities and capital is
credit therefore ASSETS = LIABILITIES + CAPITAL called fundamental accounting equation.

Assets are those resources which “we own” and on the other hand liabilities and owner’s equity
are the “sources to supply the resources (assets)” in business. Assets are the resources in
business which are supplied either by owner and/or supplied by the outsiders. Hence, capital is
the claims or rights of owner(s) against the assets of business where as liabilities are the claims
or rights of external(s) against the assets of business. A mathematical presentation of accounting
equation with respect to resources supplied by the owner(s) and or external(s) is given below.

If resources in business are supplied by the owner only then accounting equation looks like as:

Resources Sources

Assets
= Capital/Equity

DEBIT CREDIT

If resources in business are supplied by the externals only then accounting equation looks like
as:

Resources Sources

Assets
= Liabilities

DEBIT CREDIT
If resources in business are supplied by the owner and outsiders then accounting equation looks
like as:

Resources Sources

Assets
= Liabilities + Capital/Equity

DEBIT CREDIT

Accounting equation for sole-proprietorship and partnership business is “Assets = Liabilities +

Capital” whereas Accounting equation for corporations is “Assets = Liabilities + Stockholders
equity”

Base for rules of debit and credit:

Increase or decrease in any account by following the dual aspect concept of accounting does not
affect the accounting equation. Assets always equal with liabilities plus capital or equity. For
instance, liability or equity can be credited or increased if an asset account is debited or
increased. It may also be possible that asset account is increased and also be decreased at the
same time. For example, purchase of machinery on cash. In this case both machinery and cash
are assets. Machinery is increased or debited and cash is decreased or credited. The main point
is that the accounting equation always be equal whatever the case may be and it provides the
basis for rules of debit and credit i.e., debit increases the normal balance of assets whereas credit
increases the normal balances of liabilities and equity and vice versa.

Base for balance sheet:

The elementary feature of any statement of financial position is that sum of all assets must
always be equal to sum of all liabilities plus capital/equity. This agreement or balance is the
main reason for stating the financial statement a Balance Sheet. Thus, Accounting Equation
provides the base for balance sheet which shows the financial position/health of a business on a
particular point of time.
Practice Question

Mr. Akram started a business (General Store) with cash of Rs. 500,000 and necessary fixed
assets of Rs. 900,000 on 1st January 2016. He has taken loan of Rs. 300,000 from his wife to
expand the business on 14th January 2016. He purchased merchandises of Rs. 250,000 and Rs.
150,000 on cash and credit basis respectively on 20th January for his business. He sold all
merchandises on cash and credit basis amounting to Rs. 600,000 and Rs. 100,000 respectively
on 25th of the month. Rental charges and other necessary commercial expenses of Rs. 70,000
and Rs. 140,000 respectively on 28th of January were also paid for the business. He repaid the
loan amounting to Rs. 130,000 at the end of the month.

Required:
Based on the above information of Mr. Akram’s business, you are required to:

a. Show the effect of each transaction in accounting equation for the month of
January 2016

b. Prepare a Balance Sheet as on 31st January 2016.

Solution

ACCOUNTING EQUATION
Assets = Liabilities + Capital
Date Particular Fixed Sundry Sundry
Cash Loan Capital
Assets Debtors Creditors
2016
Jan 01 Investment 500,000 900,000 1,400,000
BALANCE 500,000 900,000 1,400,000
“” 14 Loan taken 300,000 300,000
BALANCE 800,000 900,000 300,000 1,400,000
“” 20 Purchases (250,000) 150,000 (400,000)
BALANCE 550,000 900,000 300,000 150,000 1,000,000
“” 25 Sales 600,000 100,000 700,000
BALANCE 1,150,000 900,000 100,000 300,000 150,000 1,700,000
“” 28 Expenses paid (210,000) (210,000)
BALANCE 940,000 900,000 100,000 300,000 150,000 1,490,000
“” 31 Loan repaid (130,000) (130,000)
BALANCE 810,000 900,000 100,000 170,000 150,000 1,490,000
The total balance of assets is always equal to total balance of liabilities plus capital balance at
each transaction. For example balance after 14 of January 2016 shows that

Assets = Cash of Rs. 800,000 + Fixed assets of Rs. 900,000

= Rs. 1,700,000

Capital = Rs. 1,400,000

Liabilities = Loan of Rs. 300,000

= Rs. 300,000

It can be presented in accounting equation as:

Assets = Liabilities + Capital

1,700,000 = 300,000 + 1,400,000

1,700,000 = 1,700,000

Another example by taking the balance after 31st of January 2016 shows that

Assets = Cash of Rs. 810,000 + Fixed assets of Rs. 900,000 + Sundry debtors of
Rs. 100,000

= Rs. 1,810,000

Capital = Rs. 1,490,000

Liabilities = Sundry creditors of Rs. 150,000 + Loan of Rs. 170,000

= Rs. 320,000

It can be presented in accounting equation as:

Assets = Liabilities + Capital

1,810,000 = 320,000 + 1,490,000

1,810,000 = 1,810,000

The same results will be found by taking the balance at the end of other transactions. Hence we
can prove that ASSETS = LIABILITIES + CAPITAL at any point of time.
The financial position of a business as on 31st January 2016 can be viewed in balance sheet as:

MS-----

Balance sheet

As on 31st January 2016

Assets Rs. Liabilities and Capital Rs.

Cash in hand 810,000 Loan 170,000

Sundry Debtors 100,000 Sundry Creditors 150,000

Fixed Assets 900,000 Capital 1,490,000

1,810,000 1,810,000

Note: Please consult recommended books mentioned in “books” Tab of

VU-LMS for more practice.