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Remember in Lesson 2 we learned the basic form of the accounting equation as:

Assets = Liabilities + Owners Equity

Now that we also understand the terms Revenue, Expense and Drawings, we can finally understand the accounting equation in its complete form. Let’s take a look.

Assets + Expenses + Drawings = Liabilities + Revenue + Owners Equity

In Lesson 2 we learned that the left side is known as the debit side and the right side is known as the credit side. The same rules apply here, only now we have some new additions to each side.

The Debit Side             

The debit side now consists of not only Assets, but also Expenses and Drawings.

The Credit Side

The credit side now consists not only of Liabilities and Owners Equity, but also Revenue.

Let’s look at some common transactions that might occur in your day to day business, and how they are recorded in the accounting equation.

Example 1:Purchasing a car with cash

Step 1: Identify the accounts involved in the transaction

Let’s identify the 2 accounts involved in this transaction

  1. Bank – an Asset ( you will draw money to pay for car)
  2. Car – an Asset   (car will give you benefit for more than 1 year and is an asset)

Step 2: Determine where the accounts lie on Debit/ Credit Side

Both the accounts lie on the left hand side of the equation.

Step 3: Determine which accounts will increase or decrease

So in order to balance the equation, one asset must increase (Car) and other must decrease (Bank).

Debit side   Credit side
Assets Expenses Drawings           = Liabilities Revenue Owner’s Equity
Increase            
Decrease            

 

Example 2: Receiving revenue for selling Cakes

Step 1: Identify the accounts involved in the transaction

Let’s identify the 2 accounts involved in this transaction

  1. Bank – an Asset ( you will deposit your revenue money into Bank)
  2. Cake Sales – aRevenue account

Step 2: Determine where the accounts lie on Debit/ Credit Side

In this case, the 2 accounts lie on the opposite sides of the accounting equation.

Step 3: Determine which accounts will increase or decrease

Both the accounts could increase or decrease

But, it will be never be the case that one account is increasing and other decreasing, otherwise the equation will not balance.

In this scenario, money from cake sale will be deposited in the bank. So Assets will increase. Likewise, Revenues will increase as well

Debit side   Credit side
Assets Expenses Drawings           = Liabilities Revenue Owner’s Equity
Increase         Increase  

Example 3: Paying expenses with cash

Debit side

 

Credit side

Assets Expenses Drawings = Liabilities Revenue Owner's Equity
  1.  
     
  1.  
     








Correct! When you pay expenses, your bank account (an asset) will decrease, while your expenses will increase.

Example 4 :Owner invests money in the business

Debit side

 

Credit side

Assets Expenses Drawings = Liabilities Revenue Owner's Equity
  1.  
     








  1.  
     
Correct! When you invest money in the business, your bank account (an asset) will go up. Your owner’s equity will also increase.

Example5: Owner withdraws money

Debit side

 

Credit side

Assets Expenses Drawings = Liabilities Revenue Owner's Equity
  1.  
     


  1.  
     






Correct! When the owner withdraws money, the bank account (an asset) goes down. The amount of drawings he has taken subsequently increases.

Example 6: Pay back loan

Debit side

 

Credit side

Assets Expenses Drawings = Liabilities Revenue Owner's Equity
  1.  
     




  1.  
     




Correct! When you pay back your loan, your bank account (an asset) is going to decrease. However, your debt will decrease also!

Notice every time the equation balances. If a debit account increases, then another debit account decreases. There will never be a time when two debit accounts increase, because then the equation won’t balance!

Similarly, it’s also common to see a debit account increase and then a credit account increase with it. This also allows the equation to balance. You will never see a debit account increase and a credit account decrease, because the equation will be left out of balance.

At the end of the day, the equation is just basic maths you learned at school!

1 = 1

If you add 5 to one side, we have to add 5 to the other side, otherwise it will simply be wrong:

1+5 = 1
Wrong!

Or, we can minus 5 from the same side to keep it balanced.

1+5-5 = 1

Don’t let the debits and credits confuse you. At the end of the day, it’s all just good ol’ pluses and minuses.

If you’re still not quite getting it, don’t worry. In the following lesson, we’ll look at some examples of recording transactions to get some practice at using the full accounting equation.

 

 

 

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