Explain the accounting equation and the rules of double-entry recording.

What this dot point is asking

The accounting equation is the foundation of the whole recording system. It expresses the simple idea that everything a business owns (its assets) is funded either by what it owes to outsiders (liabilities) or by what the owner has contributed and earned (owner's equity). Written formally:

Because it is an equation, both sides must always be equal. If a single number on one side changes, something else must change to restore the balance. This is not a coincidence; it is built into how we record transactions.

The five element groups

• Assets: resources controlled by the business that provide future economic benefit (cash, debtors, inventory, equipment).
• Liabilities: present obligations to transfer economic resources (creditors, loans, bank overdraft).
• Owner's Equity: the residual interest of the owner ($Equity = Assets - Liabilities$). It is increased by capital contributions and revenue, and decreased by drawings and expenses.
• Revenue: inflows that increase equity (other than owner contributions).
• Expenses: outflows that decrease equity (other than drawings).

Revenue and expenses are really sub-parts of owner's equity, which is why the expanded equation is sometimes written:

Debits and credits

Every account has two sides: a left side called debit (Dr) and a right side called credit (Cr). The rules flow directly from the equation. Assets sit on the left of the equation, so they increase with debits. Liabilities and owner's equity sit on the right, so they increase with credits.

Double-entry means every transaction is recorded in at least two accounts, with total debits equal to total credits. Because debits always equal credits, the equation can never go out of balance. This dual effect also gives a built-in error check: if a trial balance does not balance, a recording mistake has been made.

A reliable three-step method

For any transaction, work through three questions in order. First, which elements are affected (assets, liabilities, equity, revenue or expenses)? Second, does each one increase or decrease? Third, what debit or credit does that direction require, given the element's normal balance? Deciding the element type before the direction stops you guessing. For example, "paid the electricity account in cash" affects an expense (Electricity, increasing, so debit) and an asset (Cash, decreasing, so credit). The method works for every transaction in the course, from simple cash payments to GST-inclusive credit sales.

The expanded equation and GST

In the TASC course almost every external transaction also moves GST. GST collected on sales and GST paid on purchases sit in the GST clearing account, a liability. When you record a $1\,100$ cash sale that includes $100$ GST, the asset Cash rises by the full $1\,100$ (debit), revenue Sales rises by $1\,000$ (credit), and the liability GST clearing rises by $100$ (credit). The two credits ($1\,000 + 100$) equal the single debit ($1\,100$), so the equation still balances. Keeping the GST as a separate liability is what stops revenue being overstated.

Effect on the financial statements

Because the equation underpins both reports, reading a transaction's equation effect tells you in advance how the statements will change. A revenue or expense flows through profit into owner's equity on the balance sheet, while an asset or liability change appears directly on the balance sheet. This is why a single recording error here flows straight into the income statement and the balance sheet, and why examiners test the equation effect of transactions so often.

Worked example

Why this matters

Once you can read any transaction in terms of its effect on the five elements, you can record it correctly in journals and ledgers, and you can predict how the financial statements will change. Examiners often give a transaction and ask which two (or more) accounts move and in which direction, so practising the equation effect for each transaction is the most reliable preparation.