Tag: accounting equation

Debits and Credits

 

These two words are typical to the world of accounting and they relate to the Accounting Equation: –

Assets = Liabilities + Owners’ Equity

Under what we called double entry system in accounting, each transaction must be recorded TWO times. For example, when you as an owner of an entity you contribute capital to the business by opening a bank account lets say $10,000, the following entry is made: –

Dr. Cash at bank                $10,000 (Asset)

Cr. Paid-up share capital      $10,000 (Owners’ Equity)

Note: Dr. represents “debit” and Cr. represents “credit”

Points to note: –

1. All assets item when recorded initially, you must follow the convention of “debiting” the account relating to that particular asset.

2. All liabilities item and Owners’ Equity item on the other hand you must “credit” the relevant accounts relating to that item when you first recognise them.

Refer to the above example, if right after you have contributed the capital to the business and there are no further transactions till the end of the financial year (this is the last day of the period that you wish to set as the financial period for your business entity, 12 months is the full financial period in a year) say 31 December 2006, the Balance Sheet of your business as at 31 December 2006 looks like this: –

ABC Co. Limited

Balance Sheet as at 31 December 2006

 

$

Assets

 

Cash at bank

10,000

TOTAL

10,000

 

 

Liabilities

–

 

 

Owners’ Equity

 

Paid-up share capital

10,000

TOTAL

10,000

 

The above balance sheet shows the financial position of ABC Co. Limited as at 31 December 2006 i.e. on this date, the entity has $10,000 worth of asset, cash at bank to be specific, which is financed or represented by the $10,000 of paid-up share capital contributed by its owner. Can you see that with the figures included, the Accounting Equation has now become meaningful? Of course in this example, the entity has no liabilities.

The Accounting Equation

 

You can find a lot of materials on-line about what accounting is about and you will not miss them mentioning The Accounting Equation: –

ASSETS = LIABILITIES + OWNERS’ EQUITY

Assets are simply those things that are valuable to an entity and they include items such as the equipment bought and used in business, the trade receivables, cash kept at banks, inventories & etc. Generally, the entity must have some form of control over these items and enjoy the benefits that these items would bring to the entity. It is easier to understand the meaning of benefits to the owner if you could picture that by using the assets in your business, they would help generate the sales/revenue which is important to a profit orientated entity. (Mmm… leave your thoughts on profit to later discussions – How well an entity manage/use the assets and also the liabilities will have an outcome on the profit to be generated by the entity)

An entity does not own an asset out of nothing (Remember the old phrase – there is no free lunch in this world?). Yes, either you pay for it using your own money (i.e. Owners’ Equity) OR if you don’t have any money, borrow (i.e. Liabilities). Yes, that is the meaning of the accounting equation – All the assets of an entity must equal to the sum of all the liabilities plus the owners’ contributions to the business! Simple right? If you stick to this formula in recording EACH and EVERY transaction of an entity over a period of time, you would get a set of accounts in which the outcome of is what we call a BALANCE SHEET (Some refer to this as a Statement of Assets and Liabilities) and INCOME STATEMENT (Some refer to this as a Profit and Loss Account), which we will discuss in later topics.