by Michael Nnopu

Created on: June 21, 2010   Last Updated: June 23, 2010

Whenever a business or an entity is established, it is pertinent that records of its transactions or economic activities be properly kept. In whatever form these records are kept, it should always reflect at any particular point in time the financial position of the business or entity. One of the methods of doing this is through the accounting equation or balance sheet equation. The accounting equation which is the bedrock of financial accounting is the starting point of understanding financial accounting.

Just like a mathematical equation which is a statement that two expressions are equal, likewise an accounting equation must always equal. Whatever affects one side of the equation must reverberate or be felt on the other side. The accounting equation is basically an introduction to the financial statement or the balance sheet. Business transactions or economic activities have either a positive (+) or negative (-) effect on the accounting equation. The effects could be on the assets, capital or liabilities.

In its simplest form, the accounting equation means that the resources supplied in the business (represented by capital or owners equity) must equal its assets (what the resources acquired). The equation is stated thus for a business or entity not indebted to anyone or organization:

Capital             =          Assets

For a business or entity that has borrowed money or acquired assets on credit, in other words, it is indebted to others, the then equation becomes:

Capital + Liabilities     =          Assets

Liabilities here represent indebtedness or financial commitments to others. The accounting equation is often used to test the accuracy of records or entries made in the books of account of the business. Since capital represented by funds or money introduced into the business by its owners, are in turn used to acquire the assets.

From whatever point of view, the totals of the two sides are always equal. An example will suffice. If John introduces $1000 cash into his petty business, the $1000 becomes his capital represented by cash (assets) worth $1000. When he buys furniture for $500, paying cash, the equation changes to become Capital $1000 represented by cash $500 and furniture $500. If he further obtains goods worth $200 from James without paying immediately for it (credit purchases), the equations becomes capital $1000 and liabilities $200 (a total of $1200 for one side of the equation) represented by stocks $200, cash $500 and furniture $500 (also a total of $1200 for the other side of the equation). In all the transactions above, it will be noticed that the totals of the two sides are always the same. Neither the number of the transactions nor the amount involved will make the accounting equation unequal; the totals must always be the same.

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