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Accounting Equation

Double entry is recorded in a manner that the accounting equation is always in balance:

Assets = Liabilities + Equity

Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or from internal sources of finance such as share capital and retained profits (i.e. Equity). Therefore, assets of an entity will always equal to the sum of its liabilities and equity.

These 3 major categories Assets, Liabilities and Equity refer to one of the main financial statements known as the Balance Sheet. The other main financial statement we will concern ourselves with is called the Profit & Loss Statement, or Income Statement. Now let’s define some of the terms we will find on a typical Profit & Loss Statement.

Income is the money you derive from the sale of services or products to your customers.

Cost of Goods Sold is where a business combines all of its’ direct job costs needed to produce its’ products or services.

Expenses can be for various business purposes, but they must be necessary expenses incurred during the production of income.

Other Income is that amount of money your company receives from others but is not your main source of business income. Like Workman’s Compensation Dividends or Material Discounts.

Other Expense is that amount of expense that is not a part of your normal business operation. Like Federal & State Corporate Taxes.

The accounting equation may be re-arranged as follows:

Assets - Liabilities = Equity

We may test the Accounting Equation by incorporating the effects of several transactions to see whether it still balances as theorized in the accountancy literature. For the purpose of this test, we may classify accounting transaction into the following generic types:

• Transactions that only affect Assets of the entity

• Transactions that affect Assets and Liabilities of the entity

• Transactions that affect Assets and Equity of the entity

• Transactions that affect Liabilities and Equity of the entity

Note:

For all the examples on the next pages, it will be assumed that before any transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are $5,000 each.