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Pooja, Lovely Professional University Unit 5: Accounting Equation and Accounting Cycle

Unit 5: Accounting Equation and Accounting Cycle Notes

CONTENTS

Objectives
Introduction
5.1 Effect of Transactions on the Accounting Equation
5.2 Accounting Cycle
5.3 Summary

5.4 Keywords
5.5 Self Assessment
5.6 Review Questions
5.7 Further Readings

Objectives

After studying this unit, you will be able to:
z Explain the concept of accounting equation
z Describe accounting cycle

Introduction

The basic accounting equation is the foundation for the double-entry bookkeeping system. It

shows how assets were financed: either by borrowing money from someone (liability) or by
paying your own money (shareholders’ equity).
Assets = Liabilities + (Shareholders or Owners equity)

The accounting equation is also the basis for the most basic of accounting reports, the aptly named
Balance Sheet. A balance sheet reports what a business owns (assets), what it owes (liabilities) and
what remains for the owners (equity) as of a certain date. This equation should remain in balance
at all times because of double-entry accounting or bookkeeping. This can be further understood
by the following illustrations.

An owner’s investment into the company will increase the company’s assets and will also increase
owner’s equity. When the company borrows money from its bank, the company’s assets increase
and the company’s liabilities increase. When the company repays the loan, the company’s assets
decrease and the company’s liabilities decrease. If the company pays cash for a new delivery van,
one asset (cash) will decrease and another asset (vehicles) will increase. If a company provides
a service to a client and immediately receives cash, the company’s assets increase and the
company’s owner’s equity will increase because it has earned revenue. If the company provides
a service and allows the client to pay in 30 days, the company has increased its assets (Accounts
Receivable) and has also increased its owner’s equity because it has earned service revenue. If the
company runs a radio advertisement and agrees to pay later, the company will incur an expense
that will reduce owner’s equity and has increased its liabilities.

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