What is The Accounting Equation
The reason why each transaction is recorded twice in the accounting books is not that accountants like extra work. In effect, it is a method of checking that the entries have been made correctly. At the heart of the double-entry system is the accounting equation. This starts from the basic premise that assets liabilities equity.
It then logically builds up in complexity, as follows:
Assets = Liabilities
If there is an asset of £1, then somebody must be owed £1. This can either be a third party (such as the bank) or the owner of the business. There is thus a basic equality.
For every asset, there is a liability. Read more here about Assets Liabilities Equity
Step 2. It should be appreciated that capital is a distinct type of liability because it is owed to the owner of a business. For a listed company, capital is known as equity. If we expand our accounting equation to formally distinguish between third party liabilities and capital we now have:
Assets = Liabilities + Capital
In a sole trader, the capital is initially invested by owner. In a company, like Manchester United, the capital or equity will have been invested by shareholders.
Assets = Liabilities + Capital + Profit
When an organisation earns a profit its assets increase. Profit is on tile same side a liabilities because profit is owed to the owner. Profit thus also increases the owner’s share in the business. If a loss is made assets will decrease, but the principle of equality still holds.
Assets = Liabilities + Capital + (Income – Expenses)
All we have done is broken down profit into its constituent parts (i.e., income less expenses). We have still maintained the basic equality.
Assets + Expenses = Liabilities + Capital + Income
We have now rearranged the accounting equation by adding expenses to assets. We have still preserved the
Step 6. In accounting terms, assets and expenses are recorded using debit entries and income, liabilities and capital are recorded using credit entries. Each page of each book of account has a debit side (left-hand side) and a credit side (right-hand side). This division of the page is called a ‘T’ account, with debits being on the left and credits on the right. Thus:
The ‘T’ account is central to the concept of double-entry bookkeeping.
In turn, double-entry bookkeeping is the backbone of financial accounting.