The accounting equation is a crucial component regarding the manner in which accounting within an organization is being carried out. If for example, a person has to make the purchase of furniture then, there would be the investment of money in future and addition of asset of the organization in the form of furniture. The accounting equation in the present scenario for the organization would be as follows:
Building = Owner’s fund + borrowed capital
Asset = $400000
Capital = $30000
Liability = $100000
The cost of building for the organization is $400000. Out of this, $300000 are being the investment of capital and rest of the money is being borrowed from outside which forms organizational liability.
In case of double entry system of accounting, there is one debit and one credit entry. The total of debt and credit is equal to one another for the organization. Accounting equation of the organization is being known as balance sheet equation or financial accounting equation. It provides the relationship between assets, liabilities and owners’ funds. If there is a transaction then, it has a debit and a credit entry which helps in ensuring that, both the transactions are being matched in the accounting entry.
Assets = Capital + External liabilities (Sole proprietorship)
Assets = Stockholders equity + external liabilities
Assets: These are the resources which are being owned by a particular organization.
External liabilities: Liabilities are the obligations which are required to be met by the organization.
Stock Holders Capital: This is the amount of money being invested by the shareholders in lieu of the shares being provided by the organization.
Different Kinds of Accounting Equations
Assets = Capital + External liabilities
Assets – Capital = External liability
- Assets: Increase in assets is debited and the decrease in assets is credited
- Liability: Increase in liability is credited and the decrease in liability is debited
- Capital: Increase in the capital is credited and the decrease in the capital is debited
Example of Accounting Equation:
A person is looking forward to opening a new business. He buys shares worth $200000 of an organization. It enhances the value of cash in the organization as well as its equity capital. The cash is increased by $200000 and capital is being increased by $200000. Mr. A has made a decision to make the purchase of machinery of the company. Here, cash will increase and machinery in the form of an asset of the organization will decrease. Mr. A takes a loan from the bank. Therefore, bank balance will increase and liability of Mr. A will also increase with the same amount being obtained in the form of a loan.
Application of Accounting Equation
Double entry bookkeeping System: The accounting equation helps in providing double entry bookkeeping system. It shows that, for every debit, there is a credit.
Investment: The accounting equation helps in finding out the net worth of the organization. It also provides information about the organizational funds to the investors regarding the place where the funds are being invested by the investors.
Company’ Worth: The worth of the company is being identified as it helps in finding out the level of money being invested by the investors along with the level of money which is being invested by outsiders in the organization.
Income and Retained Earnings: The income and expenditure account provides information regarding the income earned by the organization with the same information being available to it. This helps in analyzing whether the organization is earning profits in the area of its working or not.
Expanded Accounting Equation
The accounting equation is being expanded not in terms of assets and liabilities but in terms of equity. The equity capital of the organization is being divided into four different parts.
- Owner’s capital
- Owners’ withdrawal
The equity of the organization is being formed by adding up the contribution of investors and profit being earned by the organization. There are different categories of owners for different kinds of businesses. Therefore, the elements of equity capital also change to a certain extent for the organization at a particular point in time.
Sole Proprietorship: Assets = Liabilities + owners capital – withdrawals + revenues – expenses
Assets = ( Liabilities + Member”s Capital – Distributions + Revenues – Expenses) /Member”s Equity
Assets = ( Liabilities Common Stock- Dividends + Paid In capital- Treasury Stock Distributions + Revenues – Expenses) / Member”s Equity
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