The Meaning of Accounting Equation

The Meaning of Accounting Equation The whole of financial accounting is based on the accounting equation. For a firm to operate resources are required and these resources are supplied to the firm by

someone. The resources possessed by the firm are known as assets and obviously, some of the resources will have to be supplied to the firm by the owner of the business. The total amount supplied by him is known as his capital. If he was the only one who had supplied the assets them capital must equal assets. On the other hand, some of the assets will normally have been provided by someone other than the owner. The indebtness of the firm for these resources is known as liabilities. The capital must be equal to assets minus liabilities. Two sides of the equation are, therefore, equal. On the one side are the resources possessed and on the other side are the sources from which these resources were obtained. The equity of the two sides will always be true, no matter how many transactions are entered into. The actual assets, capital, and liabilities may change but the equality of the assets with that of the total of capital and liabilities will always hold true. Capital is often called the owner’s equity or net worth.

 Accounting Equation

American accountants have derived the rules of debit and credit through accounting equation which is given below:-

Assets  =  Equities

The equation is based on the principle that accounting deals with property and rights to property and the sum of the properties owned is equal to the sum of the rights to the properties. The properties owned by a business are called assets and the rights to be properties are known as liabilities or equities of the business. Equities may be divided into equities of creditors representing debts of the business known as liabilities and equity of the owner known as capital. Keeping in view the two types of equities the equation given above can be stated as below:-

 Assets =  Liabilities + Capital

Or

Capital =  Assets – Liabilities

Or

Liabilities = Assets – Capital

 [ Also Like Financial statements are prepared primarily ]

Role of Accounting Equation

•  Regarding Assets: Increases in  assets are debits and decreases in assets are credits
• Regarding Liabilities: Increases in liabilities are credits and decreases in liabilities are debits
• Regarding Capital; Increases in the capital are credits and decreases in the capital are debits
• Regarding Expenses: Increases in expenses are debits and decreases in expenses are credits
• Regarding Incomes or Profit: Increases in incomes or profits are credits and decreases in income or profits are debits.