Double entry is recorded in a manner that the accounting equation is always in balance:
Assets = Liabilities + Equity
Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or from internal sources of finance such as share capital and retained profits (i.e. Equity). Therefore, assets of an entity will always equal to the sum of its liabilities and equity.
The accounting equation may be re-arranged as follows:
Assets – Liabilities = Equity
We may test the Accounting Equation by incorporating the effects of several transactions to see whether it still balances as theorized in the accountancy literature. For the purpose of this test, we may classify accounting transaction into the following generic types:
- Transactions that only affect Assets of the entity
- Transactions that affect Assets and Liabilities of the entity
- Transactions that affect Assets and Equity of the entity
- Transactions that affect Liabilities and Equity of the entity
Note:
For all the examples on the next pages, it will be assumed that before any transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are $5,000 each.