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
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).
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Debit side |
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Credit side |
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Assets |
Expenses |
Drawings |
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Liabilities |
Revenue |
Owner’s Equity |
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Increase |
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Decrease |
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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
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
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Debit side |
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Credit side |
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Assets |
Expenses |
Drawings |
= |
Liabilities |
Revenue |
Owner’s Equity |
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Increase |
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Increase |
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Example 3: Paying expenses with cash
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Debit side |
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Credit side |
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Assets |
Expenses |
Drawings |
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Liabilities |
Revenue |
Owner's Equity |
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Example 4 :Owner invests money in the business
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Debit side |
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Credit side |
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Assets |
Expenses |
Drawings |
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Liabilities |
Revenue |
Owner's Equity |
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Example5: Owner withdraws money
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Debit side |
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Credit side |
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Assets |
Expenses |
Drawings |
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Liabilities |
Revenue |
Owner's Equity |
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Example 6: Pay back loan
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Debit side |
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Credit side |
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Assets |
Expenses |
Drawings |
= |
Liabilities |
Revenue |
Owner's Equity |
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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.