Double entry system of accounting is universally accepted. Luca Pacioli innovated this system in the written form. In double entry system double aspects of each transaction are mentioned. Two accounts are influenced for each transaction- one is debit and the other is credit. Modern writers of Accounting have innovated an arithmetical equation known as accounting equation on the basis of this dual aspect of transactions. The basis of this equation is that assets must equal the sum of liabilities and owner's equity. The equation which represents this statement is called accounting equation. This equation can be expressed as follows.
Assets= Liabilities + Owner's Equity
The accounting equation for a corporation is:Assets= Liabilities + Stockholder's Equity
This relationship is referred to as the basic accounting equation.
Expansion of the Basic Equation:
Assets= Liabilities+(Investments+Income-Expenses-Withdraw)Assets are a company's resources—things the company owns. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner's (or stockholders') equity.
Liabilities are a company's obligations—amounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways:
(1) as claims by creditors against the company's assets, and
(2) a source—along with owner or stockholder equity—of the company's assets.
Owner's equity or stockholders' equity is the amount left over after liabilities are deducted from assets:
Assets - Liabilities = Owner's (or Stockholders') Equity.
Owner's or stockholders' equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.
If a company keeps accurate records, the accounting equation will always be "in balance," meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of a company's accounts. For example, when a company borrows money from a bank, the company's assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double-entry accounting.
A company keeps track of all of its transactions by recording them in accounts in the company's general ledger. Each account in the general ledger is designated as to its type: asset, liability, owner's equity, revenue, expense, gain, or loss account.
