Accounting Business Reporting for Decision Making

CHAPTER 4 Business transactions 127

4.3 The accounting equation

LEARNING OBJECTIVE 4.3 Explain the accounting equation process of the double-entry system of recording.

The accounting equation expresses the relationship between the assets of the entity and how the assets

are financed. Assets are resources controlled by the entity. They can be financed by outside fund pro-

viders, which are classified as liabilities, or through inside funds, known as equity. The liabilities and

equity represent the claims against the entity’s assets. For example, if CM Enterprises has assets totalling

$5.6 million and liabilities of $4 million, then the amount of equity must be $1.6 million.

We can see this illustrated in the accounting equation as:

Assets (A) = Liabilities (L) + Equity (E)

$5 600 000 = $4 000 000 + $1 600 000

The concept of duality

An important part of understanding the effect of business transactions on an entity’s performance and

position is the concept of duality. This simply means that every business transaction will have a dual

effect. For example, the purchase of a new office building through a bank loan will increase an asset (the

building) and increase a liability (the loan):

Assets (A) = Liabilities (L) + Equity (E)

Office Building = Loan

The financial statement known as the balance sheet is based on the accounting equation. The balance

sheet reports the entity’s assets, liabilities and equity. Its common format is to show assets net of liabili-

ties (net assets), which are represented by the equity of the entity. We can also expand the equity section

of the accounting equation to show the impact of the income earned and the expenses incurred by the

entity, which will determine the entity’s profit or loss for the reporting period. Recall from chapter  1

that income is inflows or other enhancements, or decreases of liabilities, which result in an increase in

equity during the reporting period. Expenses are decreases in economic benefits that result in a decrease

in equity during the reporting period. The profit (loss) will be added (subtracted) to opening equity in

the equity section of the balance sheet. Income increases equity and expenses reduce equity. Therefore,

incorporating income and expenses into the accounting equation is illustrated as follows:

Balance sheet Statement of profit or loss

Assets (A) = Liabilities (L) + Equity (E) Income (I) − Expenses (E)

Further:

Income (I) increases Equity (E)

Expenses (E) decrease Equity (E)

Therefore:

Assets (A) = Liabilities (L) + Opening Equity (E) + Income (I) − Expenses (E)

VALUE TO BUSINESS

•   Business transactions are occurrences that affect the assets, liabilities and equity accounts of an

entity. A business transaction should be recorded when there has been an exchange of resources

between the entity and another entity or individual.

•   For each business transaction recorded, there must be evidence of the transaction and the

transaction must be measurable in monetary terms.