Lets get our hands dirty by revisiting our example where the business buys for cash equipment R5 000 and stationary R250.
After the transaction the business will have R5 250 less cash. Before the transaction the cash belonged to the business and hence was its asset. Therefore the asset Bank decrease by R5 250. Furthermore we visualise that assets decrease on the credit side and that bank should be credited by R5 250.
From the double entry principle we however know that we now need corresponding debits that adds up to R5 250. Equipment and stationary will therefore have to be debited each with R5 000 and R250 respectively for a combined amount of R5 250.
In return for the cash the business now receives equipment. The equipment is now the possession of the business and hence nothing other than its asset. Therefore the asset equipment increase by R5 000. Furthermore we visualise that assets increase on the debit side. This is the beauty of accounting. We just confirmed what we already know namely that a debit entry is required according to the double entry principle.
The business also received stationary. Stationary however will be consumed fairly quickly in usual business operations. Equipment on the other hand will be used for years with the purpose to generate income for the business. Assets have a long life time whereas expenses are consumed within a short period of time. The more expenses, all other things equal, the less will the profit be. Lower profit is negative for the owner. The result is that equity reduces due to the stationary expense that increase. We visualise that expenses that increase are debited and decrease equity. This again confirms what we knew all along from the double entry principle.
In accounting equation analysis form:
In accounting equation T-account form:
Accounting is a visual discipline. The Accounting equation could be expressed in T-account form as follows:
For every asset in the business a corresponding claim exist either by the owner(s) or third parties. In other words the assets of a business is financed either by the owner(s) or third parties such as creditors. This hence by implication means that:
Assets (A) = Owner’s Equity (O/E) + Liabilities (L)
As this is an equation the left hand side should always equal the right hand side.
Using basic mathematical operations the equation could be manipulated so that:
O/E = A – L
L = A – O/E
Expenses are linked to a decrease in assets or an increase in liabilities. When a business for example have to pay for stationary it could either pay it in cash which results in a decrease of the asset bank OR will have to pay in future resulting in the increase of a liability creditors.
Expenses have the effect of decreasing what the business owes the owner(s) and hence reduces equity. Examples include: stationary, cost of sales, rent paid, interest paid, advertising, telephone, etc.
Income is closely linked to increases in assets OR a decrease in liabilities. If a business sell goods or render services it will immediately receive cash or the future right to the cash i.e. debtors. Both cash and debtors are assets. When third parties i.e. creditors encourage the business to settle debt as soon as possible an income discount received will result which have the effect of reducing liabilities. Examples of income includes: Sales, Services Rendered, Rent Received, Interest Received, etc.
Income increases the equity of the owner(s). The more the income, the more the business owes the owner(s).
Drawings is what the owner(s) takes out of or remove from the business. It has the effect of reducing what the business owes the owner(s). In other words it reduces the equity. Other than cash the owner could remove stock or stationary out of the business for own use.
Capital is what the owner(s) contribute to the business and forms part of equity as the business owes this to the owner(s). The capital could be contributed in the form of cash or assets.
Equity is what the business owes to the owner/s. Similar as for liabilities the business owes, the only difference is that it is to the owner/s rather than to third parties. Included in equity is capital, drawings, all forms of income and expenses.