The accounting equation is a fundamental principle in accounting that illustrates the relationship between a company’s assets, liabilities, and owner’s equity. It is expressed as:
Assets = Capitals + Liabilities
“The accounting equation represents the relationship between the assets, liabilities and capital of a business and it is fundamental to the application of double entry bookkeeping where every transaction has a dual effect on the financial statements”. – Association of Chartered Certified Accountants – ACCA
This equation serves as the foundation for the double-entry bookkeeping system, ensuring that every financial transaction affects at least two accounts, keeping the equation balanced. It provides a clear snapshot of a company’s financial position, showing what the company owns (assets), what it owes (liabilities), and the residual interest in the assets (owner’s equity).
Regardless of how the accounting equation is presented, the totals on both sides will always balance, irrespective of the number of transactions. While the individual amounts for assets, capital, and liabilities may fluctuate, the sum of the assets will always equal the sum of capital plus liabilities. In other words, the capital will always equal the assets of the business minus the liabilities.
Assets encompass various properties, such as buildings, machinery, inventory, and vehicles. Other assets include receivables from customers and the balance in the organization’s bank account.
Liabilities consist of amounts owed by the business for goods and services received but not yet paid for, as well as any borrowed funds.
Capital, also known as the owner’s equity or net worth, includes the funds invested in the business by the owner, retained profits for business use, and any profits paid out to the owner.
Re-write the equation
Assets = Owner’s Equity + Liabilities
Accounting equation for a corporation is:
Assets = Liabilities + Stakeholders Equity
Elements of Accounting Equation
There are two fundamental elements of an accounting equation. They are: (1) What the business owns, i.e. total assets, and (2) What the business owes, i.e. total equity.
In contrast to the basic accounting equation, the expanded version functions like a financial blueprint, dissecting a corporation’s equity into its building blocks: share capital, retained earnings, and the impact of transactions like dividends and withdrawals.
The expanded accounting equation builds on this foundation by providing more detail on the equity side of things. Here’s what it looks like:
Assets = Liabilities + Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock
Let’s break down the additional terms:
Paid-in Capital: This represents the money or other assets that owners have invested in the company. It includes things like common stock and additional paid-in capital.
Revenues: This is the income generated by the company from its core operations.
Expenses: These are the costs incurred by the company in running its business.
Dividends: These are the distributions of profits made by the company to its shareholders.
Treasury Stock: This refers to shares of a company’s own stock that it has bought back from investors.
Example shows step by step changes of accounting equation
Example 1: Suppose $100,000 cash is invested to start a business.
Assets: $100,000 (cash)
Liabilities: $0
Equity: $100,000
So, the accounting equation would be:
$100,000 (Assets) = $0 (Liabilities) + $100,000 (Equity)
Example 2: business purchases an equipment $40,000 and pays $20,000 cash for it, with the remaining $20,000 credit.
Assets: Cash is reduced by $20,000 from $100,000, so cash is $80,000; Machinery added $40,000, so total assets are $120,000.
Liabilities: $20,000 debt
Equity: $100,000
The accounting equation would be:
$120,000 (Assets) = $20,000 (Liabilities) + $100,000 (Equity)
Example 3: Business sells $10,000 and receives all cash.
Assets: Cash increased from $80,000 to $10,000, totaling cash of $90,000.
Liabilities: Unchanged, $20,000.
Equity: Gain from sale adds $10,000, so Equity is $110,000.
The accounting equation would be:
$130,000 (Assets) = $20,000 (Liabilities) + $110,000 (Equity)
More Resources
Thank you for visiting our site expartinaccounting.com and reading our resources on the Accounting Equation. Enhancing your knowledge more and progressing in your career, you may find the following guides helpful: