The Accounting Equation
We have often heard the expression “the books are in balance” in reference to the accounting records of a business. This relates to the use of the double-entry system of accounting, which says that every transaction will affect two accounts. Because the monetary values are equal we say the transaction is “in balance.” Accounting is based on a simple rule, called the accounting equation.
Using a two pan scale as illustration, the Accounting Equation is really:
The accounting Equation describes items owned by the business on one hand, and the financing of these items on the other hand.
Assets are the items owned by the business and are represented on the left side of the equation.
Capital and Liabilities represent the financing activities of the business and are represented on the right side of the equation
Assets may include land and buildings, machinery, motor vehicles, fixtures, cash on hand and money in the bank, as well as debts owed by customers.
Liabilities represent money owed by the business due to borrowings and credit arrangements including amounts owed by the business for goods and services supplied and unpaid expenses incurred by the business.
Capital is the amount of resources supplied by the owner. This includes investments by the owner as well as retained profits from ongoing business operations.
The accounting equation uses “simple math” and involves only addition and subtraction.
Regardless of the number of transactions, the Accounting Equation will always balance. The respective values of assets, capital and liabilities may change but total assets will always be equal to the total of capital and liabilities. This is because:
Assets = Capital and Liabilities
any item owned by the business must come from some source of financing
Types of Ledgers
Accounting entries are made in books called Ledgers. Most businesses use the following ledgers:
-Sales Ledger: This book contains the personal accounts for customers or debtors.
-Purchases Ledger : This book contains the personal accounts for suppliers or creditors.
-General Ledger: The remaining double-entry accounts such as those related to capital, fixed assets, expenses and revenues ( except for cash account and bank account ) are entered in the general ledger.