Meaning

Balance sheet equation is also known as accounting equation. Total of assets of the business are acquired from the funds of the business. These funds can be the investment by the proprietor i.e. capital or borrowed from some outsider known as Liabilities. It can be put in the form of a simple equation:

Total assets = Capital +Liabilities

OR

Capital + Liabilities = Assets—————-→C+L=A

This equation is known as Balance sheet equation as the Balance Sheet is based on this equation.

Balance Sheet is a financial statement prepared at the end of the accounting period for the purpose of showing the financial position of an entity in terms of Capital, Liabilities and Assets.

This Equation must stand true in all the cases even after hundreds of transactions.

It means:

Increase in one asset→ Decrease in another asset or Increase in capital or Liabilities and vice versa.

Decrease in one asset→ Increase in another asset or Decrease in capital or Liabilities and vice versa.

In short: C——-L or A, C——-L or A, so on.

So it becomes important to know when the increase or decrease in these items takes place.

Capital increases in the following cases: Introduction of new or additional capital, incomes, gains, profits, revenues.

Capital decreases in the following cases:Drawings, losses, expenses.

Liability increases in the following cases:New or more borrowings, interest thereon, expenses due to be paid, Income received in advance.

Liability decreases in the following cases:Repayment of borrowings.

Asset increases in the following cases:In case of acquiring/ purchase, appreciation.

Asset decreases in the following cases:In case of disposal/sale, depreciation, accident.

Illustration

  1. Proprietor started business with cash₹ 20,000.
  2. Borrowed from ABC bank ₹15,000.
  3. Purchased machinery for cash₹10,000.
  4. Purchased goods worth₹6,000 on credit from Seller.
  5. Repaid ₹10,000 to ABC bank.
  6. A part of machinery worth ₹3,000 was damaged in accident (machinery was not insured).
Capital₹ Liabilities(ABCbank+Seller)₹ Assets(cash+bank+mach.+goods)₹
20,000 ———— 20,000
20,000 15,000 20,000+15,000
20,000 15,000 10,000+15,000+10,000
20,000 15,000+6,000 10,000+15,000+10,000+6,000
20,000 5,000+6,000 10,000+5,000+10,000+6,000
17,000 5,000+6,000 10,000+5,000+7,000+6,000

Here the total of both the sides of Balance sheet equation are same, C+L=A stands at ₹28,000.

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