In order to use the accounting equation, you need to remember the concept of double-entry. This means that every accounting entry that you record in your books, will always impact two accounts or two categories. Every transaction must balance out as per the equation. Or as we say in accounting jargon, every debit must have an equal and opposite credit side. Let us look at some examples to understand this.
Tom formed a company by paying $10 000 for the initial shares on 1 March 2023.
Assets = Equity + Liabilities
+$10 000 = +$10 000
[Dr Bank] [Cr Share Capital]
Tom borrowed $5 000 from the bank on 2 March 2023.
Assets = Equity + Liabilities
+$5 000 = +$5 000
[Dr Bank] [Cr Bank Loan]
Tom bought equipment to the value of $2 000 in cash on 3 March 2023.
Assets = Equity + Liabilities
+$2 000 =
[Dr Equipment]
-$2 000
[Cr Bank]
In this scenario, Tom simply exchanged one asset for another asset. We used $2 000 from our bank account. Therefore, we will credit or reduce the bank account with $2 000. But at the same time, in order to balance the equation out, we will debit or increase the Equipment account with $2 000. The net result is zero.
Tom bought $3 000 of inventory on credit from the local supplier on 4 March 2023.
Assets = Equity + Liabilities
+$3 000 = +$3 000
[Dr Inventory] [Cr Accounts Payable]
Note, that even though Tom did not spend actual cash on the purchase of inventory, we still need to record it in the books. This is known as the accrual method of accounting. The accrual method means that you record transactions when they are incurred. Whereas the cash method of accounting, means that you only record transactions in your books when actual money was spent or received. You will always follow the accrual basis of accounting since this is the internationally accepted norm of accounting practice. Furthermore, CRA requires all businesses to use the accrual method of accounting.
Tom sold inventory to a customer for $7 000 in cash on 5 March 2023. The inventory items originally cost Tom $750.
Assets = Equity + Liabilities
+$7 000 = +$7 000
[Dr Bank] [Cr Retained Earnings]
-$750 = -$750
[Cr Inventory] [Dr Retained Earnings]
Tom paid interest on the loan of $50 on 6 March 2023.
Assets = Equity + Liabilities
-$50 = -$50
[Cr Bank] [Dr Retained Earnings]
Tom paid an installment of $200 on the bank loan on 7 March 2023.
Assets = Equity + Liabilities
-$200 = -$200
[Cr Bank] [Dr Bank Loan]
Tom paid himself a salary of $500 on 8 March 2023.
Assets = Equity + Liabilities
-$500 = -$500
[Cr Bank] [Dr Retained Earnings]
Tom sold goods on credit to a customer amounting to $9 000 on 9 March 2023. The cost of the inventory sold was $1 000.
Assets = Equity + Liabilities
+$9 000 = +$9 000
[Dr Accounts Receivable] [Cr Retained Earnings]
-$1 000 = -$1 000
[Cr Inventory] [Dr Retained Earnings]
If we total up everything, we can see that the total assets of $31 500 = the sum of the equity [$23 700] + the liabilities [$7 800]. Our accounting equation balances. Therefore, we did it correctly.
So that was how the accounting equation works on the most common business transactions. To help you remember how the debits and credits work, we can summarize it as follows :
Debits occur when :
1) You have an increase in asset accounts
2) Decrease in liability accounts
3) Decrease in equity accounts
Credits occur when :
1) You have a decrease in asset accounts
2) Increase in liability accounts
3) Increase in equity accounts
So now that you hopefully understand how the accounting equation as well as debits and credits work, we can move on to the general ledger.
