What is Accounting Equation?

The accounting equation is the base of “Double Entry Book Keeping System”. The equation indicates the relation between the means owned and resources owned by the business. The definition of accounting equation with the principle of “equality” duly finds its effect on the balance sheet with the “Asset Side” being a sum total of “Liabilities and Shareholder’s Equity. This is a clear indication of “two-fold effect” as in the double entry system stating that “For every debit, there is an equal amount of credit”. The accounting equation is the primary concept for a preparation of all financial statements based on journal entries.

The accounting equation formula is expressed in the algebraic form as:

A – L = C
Or
A – L = S

Where,
A = Assets of the Entity (What the business owns)
L = Liabilities of the entity (Outsider’s Claims i.e. what the business owes to outsiders)
C or S = Capital of the Entity (Owner’s/Shareholder’s Claims i.e. Capital + Net Profit/Loss – Dividends)

The accounting equation indicates that total assets of the business are being financed from either borrowed money (liabilities) or from owner’s funds/shareholder’s money (Capital + Retained Earnings) or by reduction of existing assets.

This basic accounting equation can also be expressed as:

Liabilities = Assets – Shareholder Equity
And
Shareholder Equity = Assets – Liabilities

Accounting Equation Example

The accounting equation shows that “Asset” can be purchased from “assets” or from “Liabilities” i.e. outside borrowing or from “Owner’s Equity / Shareholder’s Equity” i.e. For purchasing a machine of $3000, one can use cash (Asset) or buy it from borrowing the money from someone (Liability) or from owner’s funds (Capital/Shareholder’s Equity).

Similarly, to pay liability of $2000, one can use some other debt (Liability) or can use some Asset (Cash or Stock) or pay it off from retained profits (Owner’s Equity).

The below table would help in explaining the basic accounting equation clearly:

Explanation

Assets

Liabilities

Shareholder’s Equity

Bringing Capital $800 to a newly started business in the form of cash/machine/assets

+

800

 

 

+

800

Buying Stock/goods of $500 from market on credit

+

500

+

500

 

 

Selling stock of $300 and using this income to pay off a the market credit to that extent

?

300

?

300

 

 

Buying a machine of $400 by making cash payment 50% and borrowing 50% of the amount. (Asset entry shows machine addition of $400 and cash reduction of $200)

+

200

+

200

 

 

Earning income say interest income of $50

+

50

 

 

+

50

Paying expenses of $100

?

100

 

 

?

100

Recording expenses, but not paying them at the moment

 

 

+

100

?

100

Paying off the borrowed amount of $200 by cash or cheque

?

200

?

200

 

 

Receiving cash $1000 for sale of an car

 

0

 

0

 

0

The above examples highlight that the accounting equation holds and remains true for every transaction. Here, we have used plus sign for indication addition and minus sign for showing the reduction, however, in double entry system of book-keeping, the reduction and increase is shown by recording debits and credits.


Last updated on : July 29th, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Revaluation of Long-Lived Assets
  • Meaning and Different Types of Assets
    Meaning and Different Types of Assets
  • Fund Flow Statement
    Fund Flow Statement
  • Owner’s Equity
    Owner’s Equity
  • Capitalizing Versus Expensing Costs
    Capitalizing Versus Expensing Costs
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook


    Related pages


    inventory to cost of goods sold ratiodiluted earnings per share calculationaccounting differential analysisbullet maturity bondprogram budgeting advantages and disadvantagesearning based valuation modelwacc calculation exampleoverdraft facility in banksdcf formuladefinition of capital rationingaccounts payable example entryncd debenturescalculate current ratio accountingformula payback periodfeatures of capital budgeting decisionfictitious assetsdefine callable bondsprofitability ratios formula exampledebt to capital ratio analysisdefine pbtjournal entry for operating leaseline item budgeting definitionweighted average cost calculatorcredit the giverwalmart inventory turnoveroverdraft interest ratemeaning of bookkeeping in accountingcalculate depreciation expense for tax purposescontingent liabilities examplesdiscounting of billformula to calculate marginal costlessor lessee agreementnpv projectpayback period advantagesgross profit margin ratio definitionshort term solvency analysismarket value of debt waccnet present value and irrgolden growth modelhow to calculate ytmcapital budgeting decision criterialessee versus lessorpbt formulawhat is profit maximization in financebills payable and bills receivable meaningdefine lesseedegree of operating leverage dolformula to calculate inventory turnover ratiodefinition of dividends per sharedifference between accounts payable and notes payableformula of dividend per sharejournal entry for return of capitaldebit vs credit accountscalculate stock price based on dividendsdivident covernon cumulative preferred sharesadvantages and disadvantages of borrowing money from a bankexamples of restrictive debt covenantscapitalise debtis bank overdraft an expensestrengths of capmpayout policy definitionadvantage leasing corporationdirect and indirect costingwhat does the debt to equity ratio tell usaccount receivable turnover formuladefinition of paybackcalculate payback period uneven cash flowsreceivables collection perioddifference between accounts payable and bills payablethe journal entry for recording an operating lease payment wouldtangible fixed assets definitionfinding the irrredeemable sharesanother word for rationing