Accounting Equation, together with debits and credits, helps us make accounting entries in journal. In here, we discuss what this equation states and how it might have been derived.
To begin, recall our discussion on the Business Entity Concept where we learnt that the business is a new and separate entity created by owners for the purpose of making them money (profits).
And with our knowledge of the 4 types of transactions, we can say that a business would want to create/acquire assets that help it make money over a long period of time. But since a business is separate from owners and has no money of its own, it can create assets only when owners bless it with some funds (called, Capital).
In short,
which implies that:
Total value of Assets = Total value of Owners’ Funds, that is to say, the funds brought in by the owners simply took on the form of assets.
In more technical terms, it is written as follows:
Assets = Owners’ Equity (Capital + Profits)
Recall that Profit acts as both an income and a source of funds which is why it is included under the umbrella of “ Owners’ Funds ” or more technically, “ Owners’ Equity ”.
Next, let me pose a question: “Is it compulsory to fund a business entirely by our own money?”
Surely, not. Aside from Owner’s Funds, there is a second source of funds: Borrowed Funds. Today, we have banks and other lenders/lending institutions from whom we can borrow money and fund our business over & above our personal capital. Thus,
Consequently,
Total value of Assets = Total value of Owners’ Funds and Borrowed Funds.
Now, coming back to the more technical version, it would be as under:
Assets = Equity + Liabilities
Note that even though equity is sort of a liability, in the usual scenario, the word ‘Liabilities’ is used to refer to only the third-party obligations of a business (i.e., obligations toward lenders).
The equation above i.e., Assets = Equity + Liabilities is what came to be known as the “Accounting Equation”. A concept similar to this equation was presented by a person named Luca Pacioli in 1494. He stated:
Money entrusted by owners to business = Money owed by business to the owners.
We’ll dissect this statement properly in our next discussion and find out how it is linked to our accounting equation.
Reference
NCERT Class 11 Accountancy, Topic 2.2.6 Dual Aspect Concept –
https://ncert.nic.in/textbook/pdf/keac102.pdf
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