The Accounting Equation and How It Stays in Balance..

 



Lesson 3


The accounting equation is the unifying concept in accounting that shows the relationships between and among the accounting elements: assets, liabilities, and capital.

In this lesson (and the next ones), you will learn about the basic accounting equation and how it stays in balance.

Before taking this lesson, be sure to be familiar with the accounting elements.

Basic Accounting Equation

When a business starts to operate, its resources (assets) come from two sources: contributions by owners and resources acquired from creditors or lenders. In other words, all assets initially come from liabilities obtained and owners' contributions. This is the idea of the accounting equation.

The basic accounting equation is:

Assets = Liabilities + Capital

As business transactions take place, the values of the accounting elements change. The accounting equation nonetheless always stays in balance.

Every transaction has a two-fold effect. Meaning, at least two accounts are affected. Let's illustrate all of that through these examples.

Assume the following transactions:

Mr. Alex invested $20,000 to start a printing business,The company obtained a loan from a bank, $30,000,The company purchased printers and paid a total of $1,000.

How will the transactions affect the accounting equation?

Let us take a look at transaction #1:


Again, every transaction has a two-fold effect. In the above transaction, assets increased as a result of the increase in Cash. At the same time, Capitalincreased due to the owner's contribution. Remember that capital is increased by contribution of owners and income, and decreased by withdrawals and expenses. No liability is affected hence, stays at zero.

Let's continue with transaction #2:


In transaction #2, the company received cash. Thus, the value of total assets is increased. At the same time, it incurred in an obligation to pay the bank. Therefore, liabilities are increased. The liability in this case is recorded as Loans Payable.

Notice also that the accounting equation is still equal (balanced).

Let's add transaction #3:



The company acquired printers, hence, an increase in assets. However, the company used cash to pay for the printers. Thus, it also results in a decrease in assets. Transaction #3 results in an increase in one asset (Service Equipment) and a decrease in another asset (Cash).

For those who are new to accounting format: The parentheses "()" around the 1,000 amount above means minus or "less".

Liabilities and capital are not affected. Still, the equation in the third transaction is equal. In this case, it has zero effect on both sides.

At this point, the balance of total assets is $50,000. The combined balance of liabilities and capital is also at $50,000.

The accounting equation is (and should always be) in balance. 







Comments

Post a Comment

Popular posts from this blog

Accounting Elements: Assets, Liabilities, and Capital

Image
  LESSON 2 The three major elements of accounting are: Assets, Liabilities, and Capital. These terms are used widely in accounting so it is necessary that we take a close look at each element. But first, let's define account. What is an Account? The term "account" is used often in this tutorial. Thus, we need to understand what it is before we proceed. In accounting, an account is a descriptive storage unit used to collect and store information of similar nature. For example, "Cash". Cash is an account that stores all transactions that involve cash receipts and cash payments. All cash receipts are recorded as increase in "Cash" and all payments are recorded as deductions to the same account. Another example, "Building". Suppose a company acquires a building and pays in cash. That transaction would be recorded in the "Building" account for the acquisition of the building and a reduction in the "Cash" account for the payment...
All Post

The Accounting Equation: More Examples.

Image
Lesson 4 To help you better understand how the accounting equation works and stays in balance, here are more sample transactions and their effects to the accounting equation. In addition to transactions 1, 2 and 3 in the previous lesson, assume the following data: Rendered services and received the full amount in cash, $500Rendered services on account, $750Purchased office supplies on account, $200Had some equipment repaired for $400, to be paid after 15 daysMr. Alex, the owner, withdrew $5,000 cash for personal usePaid one-third of the loan obtained in transaction #2Received customer payment from services in transaction #5 The transactions will result to the following effects: Examples Explained The company received cash for services rendered. Cash increased thereby increasing assets. At the same time, capital is increased as a result of the income (Service Revenue). As we've mentioned in the Accounting Elementslesson, income increases capital.The company rendered services on acco...
All Post

Basic Accounting Principles.

Image
   LESSON 1 Accounting principles serve as bases in preparing, presenting and interpreting financial statements. They provide a foundation to prevent misunderstandings between and among the preparers and users. The Conceptual Framework of Accounting mentions the underlying assumption of going concern. In addition, the concepts of accrual, accounting entity, monetary unit, and time period are also important in preparing and interpreting financial statements. Going Concern Assumption The going concern principle, also known ascontinuing concern concept or continuity assumption, means that a business entity will continue to operate indefinitely, or at least for another twelve months. Financial statements are prepared with the assumption that the entity will continue to exist in the future, unless otherwise stated. The going concern assumption is the reason assets are generally presented in the balance sheet at cost rather that at fair market value. Long-term assets are included in the...
All Post