ACCOUNTING EQUATION
All business transactions are recorded as having a dual aspect. The proprietor of the business brings capital into the business out of which the business (a separate entity) purchases assets for its use. Thus, the amount of the assets of a business is equal to the amount of capital contributed by the proprietor of the business.
Thus, Capital = Assets.
In case the capital contributed by the proprietor is insufficient, the business takes borrowing from other parties or outsiders. These parties may give loan or allow credit facilities at the time of purchase of goods. The money which is owed to outsiders and which has to be paid, sooner or latter are called liabilities. For example: Loans, Bank Overdraft, Creditors, Bills Payable, and Outstanding Expenses etc. On the one hand, the loan given by the outside parties increases the assets of the business, on the other hand, claims of creditors and lender of money on the assets of the business increase.
Hence, the sum of resources (assets) = obligations (capital + liabilities)
Therefore, Capital + Liabilities = Assets; or
Capital = Assets — Liabilities.
This equation is known as accounting equation. This equation is based on the concept that for every debit, there is an equivalent credit. The entire system of double entry book-keeping is based on this concept.
This statement is always true no matter what transactions the business undertakes. Any transaction that increases or decreases the assets of the business must increase or decrease its liabilities by an identical amount.