Accounting Equation Meaning And Concept

Assets, liabilities and capital are basic elements of accounting records of any business. Liabilities and capital are the source of finance and assets are the resources of the firm. Expenses and losses decrease the capital whereas gains and incomes increase the capital. It means every financial transaction ultimately affects on assets, liabilities and capital. A statement of equality between the resources (assets) and source of finance (capital and liabilities) is accounting equation.

If a business is to be setup and start trading, it needs resources. Let's assume first that it is the woner of the business who has supplied all of the resources. This can be expressed as:

Resources in the business = Resources supplied by the owner

The amount of the resources supplied by the owner is called capital. The actual resources that are in the business are called assets. So, above statement can be re-expressed as.

Assets = Capital

Usually, the business purchases goods from number of suppliers on credit or manage the loan, if amount of capital is insufficient in the business. Liabilities are the name given to the amounts owing to these suppliers for the assets or expenses. In another word, liabilities includes amounts owed by the business for goods and services supplied to the business and for expenses incurred by the business that have not yet been paid for. They also include funds borrowed by the business. The accounting equation can be revised as:

Assets = Capital + Liabilities

In this way accounting equation can be summarized as:

Resource in the business = Total sources of finance

OR Assets = Capital + Liabilities

This equation is fundamental in the sense that it gives foundation to the double entry book keeping. This equation holds all transactions and events at all periods of time since every transaction and event has two aspects: debit and credit. Assets are debit and capital as well as liabilities are credit. So it is also known as the balance-sheet equation.

Procedure for developing an Accounting Equation:
1. Ascertain affected heads by the given transaction.
2. Ascertain the variables (i.e. assets, liabilities and capital) of an equation affected by a transaction.
3. Find out the effect (in terms of increase / decrease) of a transaction on the variables of an equation.
4. Show the effect on the appropriate side of an equation and ensure that total of assets is equal with total of capital and liabilities.