The Basic Accounting Equation

THE BASIC ACCOUNTING EQUATION

The Basic Accounting Equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a business. It is the foundation for the double-entry bookkeeping system. The Double-entry Bookkeeping System is based on the duality principle and was devised to account for all aspects of a transaction. Under the system, aspects of transactions are classified under two main types:

1.      Debit

Debit is the portion of transaction that accounts for the increase in assets and expenses, and the decrease in liabilities, equity and income.

2.      Credit

Credit is the portion of transaction that accounts for the increase in income, liabilities and equity, and the decrease in assets and expenses.

The classification of debit and credit effects is structured in such a way that for each debit there is a corresponding credit and vice versa. Hence, every transaction will have 'dual' effects (i.e. debit effects and credit effects). Assets must be equal to the sum of Liabilities and Owners equity. It should balance after every transaction, the formula is …

 

ASSETS = LIABILITIES + OWNER'S EQUITY

Asset pertains to the resources available and used in sustaining the operation of the business. It includes cash, accounts receivable, inventory, office supplies, equipment, building, land, goodwill, patent, etc.

Classification of assets :

1.      Current  assets
Current assets are cash and other types of assets that are reasonably expected to be converted into cash, sold, or used up during the normal operating year.
Examples of current assets include : Cash, Bank, Goods, Accounts Receivable, Prepaid expenses, Inventory and Marketable securities etc.

2.      Fixed assets
Fixed assets are those assets that are used in the normal operations of the entity to produce and sell goods or perform services for customers.  Fixed assets are expected to service for a number of years are not for re-sell.
Examples of fixed assets include : Lands, cars, buildings, equipments, and furniture etc.

3.      Intangible assets
Intangible assets are those assets that have no physical substance but they are expected to provide benefits to the entity for several years.
Examples of intangible assets include : Patents, trade marks, copyrights, goodwill, franchise fees, and trade name.

Liability refers to the amount of debts owed to outside person or entity, known as creditors. It represents the claim of creditors in the assets of the business. It includes accounts payable, loans payable, notes payable, bonds payable, unearned revenue, etc.

Classification of Liabilities : 

1.      Short-term Liabilities   
Short-term liabilities are obligations of the entity that are reasonably expected to be paid or settled in the next year or the normal operating cycle.
Examples of short-term liabilities include : Short-term notes payable, accounts payable, salaries and wages payable and other types of accrued liabilities for services received but not yet paid for.

2.      Long-term Liabilities 
Long-term liabilities are those obligations that do not require payment within the next year or the normal operating cycle.  In other words, liabilities not classified as short-term are reported in the Long-term liabilities section of the balance sheet.
Examples of long-term liabilities include : Loan, bonds, and any other obligation that mature in a period more than one year beyond the balance sheet date is reported as long-term.

Equity is the amount of capital or resources invested in the business by the owner. It represents the claim of owners in the assets of the business. It consist of capital, drawing, common stock, additional paid in capital, preferred stock, retained earnings, net income, net loss.

There are two main sources of owner’s equity :

1.      Amounts contributed by  the owner (Capital)

2.      Amount earned by the entity but not yet taken by the owner.