Accounting Equation & T-Accounts

Every accounting system is founded on the accounting equation, which expresses the relationship between the economic resources controlled by an entity and the claims of creditors and owners against those resources. The equation underpins double-entry bookkeeping, the rules of debit and credit, and the structure of the financial statements.

THE ACCOUNTING EQUATION

Assets = Liabilities + Equity

The equation must hold after the recording of every transaction. Any transaction that changes one side of the equation must produce an equal change on the same side or on the other side.

THE ELEMENTS OF FINANCIAL STATEMENTS

The following definitions are consistent with the conceptual framework of Canadian Accounting Standards for Private Enterprises (ASPE), Section 1000 of the CPA Canada Handbook.

• Assets: economic resources controlled by an entity as a result of past transactions or events, from which future economic benefits may be obtained. Categories include cash, accounts receivable, inventory, prepaid expenses, property, plant and equipment, and intangible assets.

• Liabilities: obligations of an entity arising from past transactions or events, the settlement of which may result in the transfer of assets, the provision of services or another yielding of economic benefits in the future. Categories include accounts payable, accrued liabilities, sales taxes payable, payroll source deductions payable, deferred revenue and long-term debt.

• Equity: the ownership interest in the assets of an entity after deducting its liabilities. In a corporation, equity comprises share capital, contributed surplus and retained earnings; in an unincorporated business, it is presented as the owner’s or partners’ capital.

• Revenues: increases in economic resources, either by inflows or enhancements of assets or reductions of liabilities, resulting from the ordinary activities of an entity.

• Expenses: decreases in economic resources, either by outflows or reductions of assets or incurrence of liabilities, resulting from the ordinary revenue-generating activities of an entity.

• Gains and losses: increases or decreases in equity arising from peripheral or incidental transactions, such as the disposal of capital assets.

THE EXPANDED ACCOUNTING EQUATION

Because revenues and expenses change equity, the equation may be expanded as follows:

Assets = Liabilities + Contributed Capital + Opening Retained Earnings + Revenues − Expenses − Distributions

Distributions are dividends in the case of a corporation and drawings in the case of a sole proprietorship or partnership. Distributions reduce equity but are not expenses and do not affect net income.

THE DOUBLE-ENTRY PRINCIPLE

Under double-entry bookkeeping, every transaction is recorded in at least two accounts, and the total value of the debits recorded for the transaction equals the total value of the credits. This duality ensures that the accounting equation remains in balance and provides an internal arithmetic check on the accuracy of the records.

RULES OF DEBIT AND CREDIT

The terms debit (Dr) and credit (Cr) refer, respectively, to the left-hand and right-hand sides of an account. They carry no implication of a favourable or unfavourable effect. The effect of a debit or credit depends on the classification of the account:

• Assets: increased by debits and decreased by credits; normal balance is a debit.

• Expenses and losses: increased by debits and decreased by credits; normal balance is a debit.

• Distributions (dividends or drawings): increased by debits and decreased by credits; normal balance is a debit.

• Liabilities: increased by credits and decreased by debits; normal balance is a credit.

• Equity (share capital, owner’s capital, retained earnings): increased by credits and decreased by debits; normal balance is a credit.

• Revenues and gains: increased by credits and decreased by debits; normal balance is a credit.

CONTRA ACCOUNTS

A contra account carries a balance opposite to that of the account with which it is paired and is reported as a deduction from that account. Common contra accounts include accumulated amortization (contra to property, plant and equipment), the allowance for doubtful accounts (contra to accounts receivable), sales returns and allowances and sales discounts (contra to revenue), and drawings (contra to owner’s capital).

THE T-ACCOUNT

A T-account is a simplified representation of a ledger account, comprising the account title, a debit side on the left and a credit side on the right. The balance is determined by totalling each side and deducting the smaller total from the larger; it is described as a debit or credit balance according to the side with the larger total. T-accounts are used in transaction analysis, in the preparation of working papers and in the reconciliation of accounts.

TRANSACTION ANALYSIS PROCEDURE

1. Identify the transaction and obtain the supporting source document.

2. Determine which accounts are affected.

3. Classify each affected account as an asset, liability, equity, revenue, expense or distribution account.

4. Determine whether each account increases or decreases.

5. Apply the rules of debit and credit to determine the side on which each amount is recorded.

6. Confirm that total debits equal total credits and that the accounting equation remains in balance.

EFFECT OF COMMON TRANSACTION TYPES ON THE EQUATION

• Contribution of capital by owners: assets increase; equity increases.

• Acquisition of an asset for cash: one asset increases; another asset (cash) decreases.

• Acquisition of an asset on credit: assets increase; liabilities increase.

• Revenue earned on account: assets (accounts receivable) increase; equity increases through revenue.

• Expense paid in cash: assets decrease; equity decreases through the expense.

• Repayment of a liability: assets decrease; liabilities decrease.

• Distribution to owners: assets decrease; equity decreases.

CASH BASIS AND ACCRUAL BASIS

Under the cash basis, revenues and expenses are recognized when cash is received or paid. Under the accrual basis, revenues are recognized when earned and expenses when incurred, irrespective of the timing of cash flows. Both ASPE and International Financial Reporting Standards (IFRS) require the accrual basis. For income tax purposes, the Canada Revenue Agency generally requires business and professional income to be computed on the accrual basis; farming and fishing businesses may elect to use the cash method.

FINANCIAL REPORTING FRAMEWORKS IN CANADA

• IFRS (Part I of the CPA Canada Handbook): required for publicly accountable enterprises, such as entities whose securities trade in a public market.

• ASPE (Part II): available to private enterprises.

• Accounting Standards for Not-for-Profit Organizations (ASNPO, Part III): available to private-sector not-for-profit organizations.

• Public Sector Accounting Standards (PSAS): applicable to governments and certain public sector entities.

COMMON ERRORS

• Recording only one side of a transaction.

• Classifying owner distributions as expenses.

• Commingling personal and business transactions.

• Recognizing revenue on receipt of cash where the accrual basis is required.

• Recording an amount on the incorrect side of an account.

SOURCES

• CPA Canada Handbook – Accounting, Part II (ASPE), Section 1000: Financial Statement Concepts.

• Canada Revenue Agency, Guide T4002: Self-employed Business, Professional, Commission, Farming, and Fishing Income.

• Canada Revenue Agency, Keeping records.