When the sum of capital and liabilities is equal to the total assets of the business, this is called the accounting equation.
Any resources controlled by a business that can provide economic benefit to the business are called assets. For example, office buildings, furniture and fixtures, computer systems and inventory, etc. The control of resources is necessary for recognizing assets in the book of account.
If assets can’t generate benefits for the business, it would be written off in the books of account.
The money invested in a business is called capital or owner equity. This money is either used to purchase business assets or to meet day-to-day business expenses. The capital increases with the net profit earned by the business and decreases with any money withdrawn from the business for the personal use of the business owner.
Owner equity = Initial investment + Net profit earned – Drawing
Any money the business owes to others is called liability. For example, when a director gives a loan to the business. It will be recorded as a liability in accounts. When the business buys inventory on credit this also creates a liability.
Now we will try to understand the accounting equation with some illustration.
(a) Mustafa starts a laundry business. The business begins by investing $20,000 cash.
Capital Investment increased = $20,000
Cash increased = $20,000
Assets = Capital + Liability
$20,000 = $20,000 + Liability
Cash is a current asset while an initial investment of $20,000 is capital. So, both sides of the equation are equal.
(b) Mustafa purchased a computer for $1,000 and $500 Inventory purchased on credit.
Cash decreased = $1,000
Computer Increased = $1,000
Assets = Capital + Liability
$20,000 + $1,000 – $1,000 = $20,000 + Liability
Computer and cash both are assets. One asset (cash) is decreased and the other is increased (computer).
Inventory increased = $500
Account Payables increased = $500
Assets = Capital + Liability
$20,000 – $1,000 + $500 = $20,000 – $1,000 + $500
Purchased inventory on credit increased liability (Account Payables) and assets (Inventory) of the business.
Assets = Capital + Liabilities
Cash $20,000 = Initial Investment $20,000
Computer $1,000 =
Cash ($1,000) =
Inventory $500 = + Account Payable $500