The Accounting Equation

The accounting equation is a general rule used in business transactions where the sum of liabilities and owners’ equity equals assets.

Learning Objectives

Break down the fundamental accounting equation

Key Takeaways

Key Points

• This equation is kept in balance after every business transaction. Everything falls under these three elements ( assets, liability, owners’ equity ) in a business transaction.
• Assets = Liabilities + Equity.
• The fundamental accounting equation is the foundation of the balance sheet.

Key Terms

• Accounting Equation: The “basic accounting equation” is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits.
• equity: Ownership interest in a company as determined by subtracting liabilities from assets.
• liabilities: An amount of money in a company that is owed to someone and has to be paid in the future, such as tax, debt, interest, and mortgage payments.

The fundamental accounting equation, which is also known as the balance sheet equation, looks like this: $\text{assets} = \text{liabilities} + \text{owner's equity}$. On the left side of the equation are the assets of the business, including cash, accounts receivable, notes receivable, property, plants, and equipment. Or more correctly, the term “assets” represents the value of the resources of the business.

Sample Balance Sheet: A balance sheet shows how the accounting equation is applied.

On the right side of the equation are claims of ownership on those assets: liabilities are the claims of creditors (those “outside” the business); and equity, or owners’ equity, is the claim of the owners of the business (those “inside” the business). The fundamental accounting equation is kept in balance after every business transaction because everything falls under these three elements in a business transaction.

For example, when a company intends to purchase new equipment, its owner or board of directors has to choose how to raise funds for the purchase. Looking at the fundamental accounting equation, one can see how the equation stays is balance. If the funds are borrowed to purchase the asset, assets and liabilities both increase. If the company issues stock to obtain the funds for the purchase, then assets and equity both increase.

Additionally, changes is the accounting equation may occur on the same side of the equation. For example, if the company uses cash to purchase inventory, cash is decreased (credited) and inventory is increased (debited); thus, assets as a whole remain unchanged and the equation remains in balance. Likewise, as the company receives payment from its customers, accounts receivable is credited and cash is debited.

Double-Entry Bookkeeping

A double-entry bookkeeping system requires that every transaction be recorded in at least two different nominal ledger accounts.

Learning Objectives

Explain the fundamentals of accounting bookkeeping

Key Takeaways

Key Points

• In the double-entry accounting system, each accounting entry records related pairs of financial transactions for asset, liability, income, expense, or capital accounts.
• There are two different approaches to the double entry system of bookkeeping. They are Traditional Approach and Accounting Equation Approach.
• Recording of a debit amount to one account and an equal credit amount to another account results in total debits being equal to total credits for all accounts in the general ledger.

Key Terms

• debit: Debit and credit are the two fundamental aspects of every financial transaction in the double-entry bookkeeping system in which every debit transaction must have a corresponding credit transaction(s) and vice versa.
• debit card: a product that can be used to make payments by drawing money directly from the user’s bank account

Double-Entry Bookkeeping

A double-entry bookkeeping system is a set of rules for recording financial information in a financial accounting system in which every transaction or event changes at least two different nominal ledger accounts.

In the double-entry accounting system, each accounting entry records related pairs of financial transactions for asset, liability, income, expense, or capital accounts. Recording of a debit amount to one account and an equal credit amount to another account results in total debits being equal to total credits for all accounts in the general ledger. If the accounting entries are recorded without error, the aggregate balance of all accounts having positive balances will be equal to the aggregate balance of all accounts having negative balances. Accounting entries that debit and credit related accounts typically include the same date and identifying code in both accounts, so that in case of error, each debit and credit can be traced back to a journal and transaction source document, thus preserving an audit trail.

The “Golden Rules of Accounting”

The rules for formulating accounting entries are known as “Golden Rules of Accounting”. The accounting entries are recorded in the “Books of Accounts”. Regardless of which accounts and how many are impacted by a given transaction, the fundamental accounting equation A = L + OE (assets equals liabilities plus owner’s equity ) will hold.

There are two different approaches to the double entry system of bookkeeping. They are the Traditional Approach and the Accounting Equation Approach. Irrespective of the approach used, the effect on the books of accounts remain the same, with two aspects (debit and credit) in each of the transactions.

Following this approach, accounts are classified as real, personal, or nominal accounts. Real accounts are assets. Personal accounts are liabilities and owners’ equity and represent people and entities that have invested in the business. Nominal accounts are revenue, expenses, gains, and losses.

Transactions are entered in the books of accounts by applying the following golden rules of accounting:

• Personal account: Debit the receiver and credit the giver
• Real account: Debit what comes in and credit what goes out
• Nominal account: Debit all expenses & losses and credit all incomes & gains

Accounting Equation Approach (American)

Under this approach, transactions are recorded based on the accounting equation, i.e., Assets = Liabilities + Capital. The accounting equation is a statement of equality between the debits and the credits. The rules of debit and credit depend on the nature of an account. For the purpose of the accounting equation approach, all the accounts are classified into one of the following five types:

1. Assets
2. Liabilities
3. Income/revenues
4. Expenses
5. Capital gains/losses

If there is an increase or decrease in one account, there will be an equal decrease or increase in another account. There may be equal increases to both accounts, depending on what kind of accounts they are. There may also be equal decreases to both accounts. Accordingly, the following rules of debit and credit in respect to the various categories of accounts can be obtained.

The rules may be summarized as below:

• Assets accounts: Debit increases in assets and credit decreases in assets
• Capital account: Credit increases in capital and debit decreases in capital
• Liabilities accounts: Credit increases in liabilities and debit decreases in liabilities
• Revenues or Incomes accounts: Credit increases in incomes and gains and debit decreases in incomes and gains
• Expenses or Losses accounts: Debit increases in expenses and losses and credit decreases in expenses and losses

Example of Double entry bookkeping: Purchase Invoice Daybook

The Accounting Cycle

The accounting cycle includes analysis of transactions, transferring journal entries into a general ledger, revenue, and expense closed.

Learning Objectives

Outline the accounting cycle from point of transaction to financial statements

Key Takeaways

Key Points

• When a transaction occurs, a document is produced. Most of the time these documents are external to the business, however, they can also be internal documents, such as inter-office sales. These documents are referred to as a source document.
• The Journal entries are then transferred to a Ledger. The group of accounts is called ledger, or a book of accounts. The purpose of a Ledger is to bring together all of the transactions for similar activity.
• Financial statements are drawn from the trial balance which may include: the Income statement, the Balance sheet, and the Cash flow statement.
• 3. prepare trial balance
• 5. prepare adjusted trial balance
• 6. prepare financial statements
• 7. post closing entries
• 8. prepare a post closing trial balance

Key Terms

• Journal entries: A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit.

When a transaction occurs, a document is produced. Most of the time these documents are external to the business, however, they can also be internal documents, such as inter-office sales.

These documents are referred to as a source document. Some examples are: the receipt you get when you purchase something at the store, interest you earned on your savings account which is documented in your monthly bank statement, and the monthly electric utility bill that comes in the mail. These source documents are then recorded in a Journal. This is also known as a book of first entry. It records both sides of the transaction recorded by the source document. These write-ups are known as Journal entries.

These Journal entries are then transferred to a Ledger, which is the group of accounts, also known as a book of accounts. The purpose of a Ledger is to bring together all of the transactions for similar activity. For example, if a company has one bank account, then all transactions that include cash would then be maintained in the Cash Ledger. This process of transferring the values is known as posting. Once the entries have all been posted, the Ledger accounts are added up in a process called Balancing.

A particular working document called an unadjusted Trial balance is created. This lists all the balances from all the accounts in the Ledger. Notice that the values are not posted to the trial balance, they are merely copied. At this point accounting happens. The accountant produces a number of adjustments which make sure that the values comply with accounting principles. These values are then passed through the accounting system resulting in an adjusted Trial balance. This process continues until the accountant is satisfied.

Financial statements are drawn from the trial balance which may include: the Income statement, the Balance sheet, and the Cash flow statement.

Finally, all the revenue and expense accounts are closed.