ACCOUNTING EQUATION-THEORY AND PRACTICAL

Accounting equation also known as balance sheet equation is the relationship that exist between capital of a business i.e. owners equity or net worth, liabilities and assets of the business. ‘It states that the capital side total of the Balance sheet must be equal to the total assets of the business.

Assets are properties that the business possesses e.g. building, plant and machinery, cash at bank, stock, debtor etc.

Liabilities are the amount borrowed or supplied to the business by outsiders e.g. loan, bank overdraft and sundry creditors etc.

Capital is the amount the proprietor or owners of the business provided to run the business.

The equation will be as follow:

Asset = capital: where there are no liabilities

Asset – liabilities = capital

Where there are liabilities

The total side will always equal the other side of the equation. This will be true no matter how many transactions are involved.

The assets, capital and liabilities may change, but the equality of assets and that of total capital and liabilities will always show the same.

Since the equation is also known as balance sheet equation we, shall use balance sheet format to illustrate accounting equation in greater details.

Example 1

Complete the gap in the following table

S/No	Assets                  N	Liabilities                  N	Capital      N
A	300000	?	190000
B	?	14000	70000
C	?	18000	14000
D	130000	?	90000
E	260000	?	50000
F	50000000	2000000	?
G	15653	4532	?
H	4000	1000	?

                       

a.         Assets =          Liabilities + Capital

            N300,000       =          L+190,000

            L                      =          N300, 000 – N190,000

                                    =          N110,000

b.         Assets =          Liabilities + Capital

                                    =          N140,000 + N70,000

                                    =          N210,000

c.         Assets =          Liabilities + Capital

                                    =          N18,000 + N14,000

                                                N32,000

d.         Assets =          Liabilities + Capital

            N130,000       =          L + N90,000

            L                      =          N130,000 – N90,000

            L                                  N40,000

e.         Assets =          Liabilities + Capital

            N260,000       =          L + N50,000

            L                      =          N260,000 – N50,000

            L                      =          N210,000

f.          Assets =          Liabilities + Capital

            N5,000,000    =          Capital + N2,000,000

            Capital            =          N5,000,000 - N2,000,000

                                    =          N3,000,000

g.         Assets =          Liabilities + Capital

            N15,653         =          N4,532 + Capital

            Capital            =          N15,653 – N4,532

                                    =          N11,121

h.         Assets =          Liabilities + Capital

            N4,000           =          N1,000 + Capital

            Capital            =          N4,000 – N1,000

                                    =          N3,000

EFFECTS OF TRANSACTIONS ON THE BALANCE SHEET

a.         Every business transaction will have an effect on the balance sheet      since all transactions must have two bold effects.

b.        The effect of transactions will therefore either:

i.          Increase both assets and liabilities.

ii.         Reduce both assets and liabilities.

iii.        Increase some assets and reduce others.

Iv.       Increase some liabilities and reduce others.

SUMMARY OF EFFECTS OF TRANSACTIONS

(1) Introduction of capital in cash.	Increase in asset (cash).	Increase in capital.
(2) Purchase of goods on credit.	Increase in asset (stock).	Increase in liability (creditor).
(3) Sale of goods on credit.	Increase in asset (debtor).	Reduction in asset (stock).
(4) Settlement of creditor by cheque.	Reduction in liability (creditor).	Reduction in asset (bank).
(5) Cash drawings for own use by the owner.	Decrease in asset (cash).	Decrease in capital.
(6) Owner pays creditors from private money.	Increase in assets (cash).	Increase in capital.
(7) Receipt from a debtor, cash.	Increase in asset (cash).	Reduction in asset (debtor).

Balance sheet format illustration

Step I

Introduction of capital, started banners with N30, 000 by cheque

Effect: 
          increase in asset (Bank)

          Increase in (capital)

     
 The balance sheet will appear as follow

    Liability                                                                                    

    Capital                    N 30000
     Asset                               

        Bank                             N  30000

Step II purchase of assets on credit.

The business purchase motor van N16, 000 on credit.

Effect:    increase in liabilities (creditors)

Increase in assets) motor van)

The balance sheet will appear as follow:

Liabilitie                     N

Capital               30,000        

 Creditor           16,000                                                               

                         46000

Assets                          N

         Bank               30,000

    Motor van            16,000

                                46,000

                                                                                                                                                                                              

Step III:      Purchase of goods on credit of N5, 000 from Ngozi

Effect:         Increase in liability (creditor)

                    Increase in assets stock

The balance sheet will appear as follow

Liabilities                N

Capital                30000

Creditors            21000

                           51000

Assets                      N

Motor Van            16000

Stock                    5000

Bank                     30000

                            51000

Step IV:         Sold goods for cash

                      The business sold goods for cash  N3,000

Effect:           Increase in assets  

                      Decrease in stock

The balance sheet will appears as follow:

                         N        

Capital         30000

Creditor        21000

                    51000

                         N

M0tor van      16000                        

  Stock            2000

Bank              30000

Cash                3000

                       51000

                                 

Step V:          Settlement of liabilities

The business paid the creditors

N 20,000 with cheque

Effect:          reduction in liabilities (creditor)

Reduction in asset (bank)

Balance sheet will appear as follows                                              

                                       N

    Capital                      30000

Creditors                      1000

                                    31000

                                       N

Motor Van                    16000

Stock                             2000

Bank                             10000

Cash                               3000   

                                     31000

Step VI: Sold goods on credit                                                           

      He sold goods to John on credit N1000

Effects:      Reduction in assets (stock)

 increase in asset (debtor)

The Balance will appear as follow

              N

Capital                  30000

Creditors               1000

                            31,000

Motor van             16,000

Stock                      1,000

Bank                      10,000      

Debtor (John)           1.000

Cash                        3,000

                              31,000

^{Ref: Essential Financial Accounting by O.A. Longe & R.A. Kazeem and Business Accounting book 1 by Frank wood}