Assets = Capital + Liabilities
In Accounting, whenever record any transaction we consider the effect of the transaction on the accounting equation above. For all transactions the above equation has to balance. This means that every transaction must have two effects, one for each side of the above equation. Since we record both the effects we call this system of accounting the double-entry system. Consider a few transactions and see what effect they have on our equation.
- Mr. A started a business with $100,000 in cash.
This action of Mr. A has two effects on the business. First, capital increases by $100,000 and second cash in the business increases by $100,000 as well. So if we consider our equation
Assets = Capital + Liabilities
Cash goes up by $100000 = Capital goes up by $100000
We can see there that the equation balances out as we increased the asset by $100,000 and also increased the Capital by the same amount. Let us continue with some more transactions of Mr. A.
- Bought Machinery for $50,000.
This transaction will also have an impact on both sides but unlike the first contribution of capital, both changes will now be on the asset side of the equation. As one asset (machinery) is increasing while the other asset (cash) is decreasing by the same amount. So the net effect will be balance.
- Mr. A took a loan of $100,000 and bought a building for the business.
Again this will increase assets (the new building) by $100,000 and will increase the liability (the loan) of the business by $100,000.
Debit and Credit
Up until this point, we know how every transaction is treated in accounting but we are still not in the position to record the business transactions, which was the main reason why we started learning accounting. We need to first learn what T-accounts are and what debit and credit is before we record the transactions.
Each item or transaction is recorded in a separate account called a T-account. T-accounts look like a big T junction:
Name of the item
|xxxx Other account in the transaction xxx||xxxx Other account in the transaction xxx|
The left hand side of this account is called the debit side while the right hand side is called the credit side. On top of the T-account we put the name of the account. Every transaction is recorded with the date and the amount and also we put the name of the other account that is being affected as a result of this transaction. For instance, if this was the T-account for cash balance, we would note down the following transactions
- Increase in cash by 100,0000 on account of contribution of capital
- Decrease in cash by 50,000 on account of purchase of a fixed asset.
Despite the T account we are still missing some basic rules. Do we record the increase and later decrease in cash on the left side or the right side? This is where the basic rules of accounting come in handy. Here is what they look like.
An increase in asset is always debited.
A decrease in asset is always credited.
An increase in liabilities is always credited.
A decrease in liabilities is always debited.
An increase in capital is always credited.
A decrease in capital is always debited.
An increase in expense is always debited.
An increase in revenue is always credited.
Congratulations! Now you are in a position to record business transactions.
Whenever you record a transaction you start by the applicable category(-ies) involved (asset, capital, liabilities, revenue or expense) and then apply the appropriate increasing or decreasing rules. Once you have the debit and credits, you locate the relevant T-account for each item and record the transaction in it.