Question

he accounting equation is assets = liabilities + owner’s equity. Please explain the relationship between economic resources and claims to economic resources. Why must this equation always balance? What transactions increase or decrease owner’s equity? How does net income or loss affect owner’s equity? Please give an example of a transaction, applied to the accounting equation.

Answer 1

The accounting equation shows the relationship between the economic resources of a business and the claims against those resources. At all times, the following relationship holds:

Economic resources = Claims

Economic resources are assets. The claims consist of creditors claims or Liabilities, and owners claims or Equity. The accounting equation therefore can be modified as follows:

Assets = Liabilities + Equity

As per the duality concept, for every debit, there is a corresponding credit. Therefore, at any point in time, the Total Assets ( Dr. ) would equal Total Liabilities ( Cr. ) and Total Equity ( Cr. ). Therefore the accounting equation is always in balance. This balancing is as important to the accountant as safe landing is to an airline pilot. The number of times an aircraft takes off must equal the number of times it lands. This principle of duality is valid regardless of the complexity of the transaction. The double-entry system records every transaction with equal debits and credits. Therefore, the total of debits must equal the total of credits.

Transactions which increase owner's equity:

• All revenues, e.g. sales revenue, service revenue, commission income, rental revenue etc
• All gains, e.g gain on sale of assets or investments, gain on revaluation of assets, unrealized gains on investments etc
• Extraordinary income: Gain on litigation etc

Transactions which decrease owner's equity:

• All expenses, e.g., salaries expense, rent expense, advertising expense, depreciation expense etc
• Losses, e.g., Loss on sale of assets or loss on sale of investments, impairment loss, inventory write-downs, bad debts,
• Extraordinary losses e.g, loss due to floods or earthquake, litigation loss etc
• Dividends: distribution to the owners from the retained earnings of the firm.

Net income increases owner's equity, while net loss decreases owner's equity. Owner's equity is composed of capital contributions by the owner, and retained earnings built up from surpluses the firm's operations. Surpluses or profits would increase retained earnings, while losses would decrease retained earnings.