3.1.2 The accounting equation

The financial position of a business is expressed in the statement of financial position, which is more commonly called the balance sheet. The financial position of a business is represented by:

• assets (what the business owns)
• liabilities (what the business owes)
• owner’s capital (the monetary value of the owner’s investment in the business).

As you may remember from Week 2, the accounting equation (also called balance sheet equation), for any business, says:

Figure 1 below demonstrates the accounting equation.

Figure 1 Assets equal capital and liabilities

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This diagram illustrates the concept of the accounting equation.

There is a picture of a set of scales with both sides balanced. The left arm of the scales contains assets. This is balanced by the right arm of the scales, which contains capital and liabilities.

Figure 1 Assets equal capital and liabilities

The accounting equation should be kept in balance at all times i.e. the assets on the left side of the equal sign should always be the same as the sum of the capital and liabilities on the right-hand side.

Any change in assets, capital or liabilities in the business has to keep the accounting equation in balance. If, for example, the business buys goods for sale for £200 on credit from a supplier then the accounting equation will look as follows:

Assets of £10,000 + £200 (new asset) = Capital of £2,000 + Liabilities of £8,000 + £200 (new liability)

or £10,200 = £2,000 + £8,200

This increase in both assets and liabilities in this example is known as the dual effect of every transaction. The next activity will help you to understand this better.

In the next section, the dual effect – also known as the duality principle – of every transaction will be looked at in more detail.