In any Business Enterprise there are two kinds of objects namely; Assets and Liabilities. An asset is a thing on which the business has ownership and exercises the right on it. The assets always have a future economic value e.g. Building, Machinery etc. The liabilities mean the obligation of a company to any outsider. This could be any sum that a business owes e.g. Creditors, Bills Payable etc.
In a firm, the initial amount or any subsequent amount invested by the owner is called the Owner’s Equity. Similarly in a corporation, the amount is invested on a large basis and there are many owners to the enterprise. They buy Equity Shares in the company and thus such source is called Shareholder’s Funds.
An accounting equation forms the basis for any accounting function to take place. The accounting equation shows the relationship between the Assets, Liabilities and the Shareholder’s Funds in the business. An Accounting Equation works as the core ingredient on which the subsequent functions, working and maintenance of accounts is dependent.
The Accounting Equation is: Assets = Liabilities + Shareholder’s Funds (Owner’s Equity)
So basically the Accounting Equation shows how the assets in the firm have been financed i.e. whether out of the Borrowings or the capital employed by the Owner.
The Accounting Equation plays a major role in the formation of the Balance Sheet of the business.
A Balance Sheet is a summarized statement which shows the position of the company. It shows the relation between the Assets and Liabilities. It is dependent on the accounting equation. This could be understood from the following format:
|Current Liabilities||Current Assets|
|Bills Payables||Cash in hand|
|Sundry Creators||Cash at bank|
|bank Overdraft||Sundry Debtors|
|Outstanding Expenses||Bills Receivables|
|Income received in advanced||Prepaid Expenses|
|Long-term Liabilities||Accrued Income|
|Mortgage Loans||Closing Stock|
|Owner's Equity:||Government Securities|
|Reserves and Surplus||Other Investments|
|Add Net Profit||Furniture|
|Interest on Capital||Plant an Machinery|
|Less Drawings||Land and Buildings|
Thus we see that the liabilities and the owner’s equity are taken on one side and the Assets on the other. The owner’s equity is also a kind of liability to the business which is owed to the Owner and business intends to pay it back sooner or later.
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The accounting system is based on the Double Entry System. The Double Entry System shows that any transaction would affect two accounts at the same time. Thus, if there will be an increase in one type of account, there will be a simultaneous decrease in another one e.g. if a new asset is purchased and the amount is paid in cash, then there is an increase in the assets account but at the same time the cash goes out.
This double effect of any transaction renders the basis for the formation of accounting equation.
In any accounting technique the basic requirement is of reliability and correctness. The Accounting Equation is always true because it renders a simultaneous effect on two accounts at the same time. In any business accounting software the accounting equation is the core ingredient. All the accounts, ledgers, Balance Sheet, Income Statement (Profit and Loss account) are based on the Fundamental Accounting Equation. The Double Entry system will be ineffective without the Equation.
The Accounting Equation can be sometimes complicated in case of the Companies. This could be better understood using the following equation:
Assets = Liabilities + Initial Capital + Additional Capital - Drawings + (Revenue – Expenses)
Initial Capital + Additional Capital - Drawings are just the changes in the capital done by the Owner. They are the fluctuations in the Capital due to amount being invested or withdrawn.
Revenue – Expenses is nothing but the profit or loss earned by the business. This is finally added or deducted from the Capital.
The expanded equation gives a better insight to the working of the Accounting Equations.
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The basic accounting format followed is:
The applications of Accounting Equation can be different and sometimes complicated to understand. For assistance with the Accounting equation you can visit our site assignmenthelp.net. You can also take help of the online tutors available with our site who can help you in understanding the concept better. The various Accounting Assignments are available on our site for deeper insight to the topics.
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