Accounting Equation

Accounting Equation Definition

Accounting Equation is the primary accounting principle stating that a business’s total assets are equivalent to the sum of its liabilities & owner’s capital. This is also known as the Balance Sheet Equation & it forms the basis of the double-entry accounting system.

Below is the Accounting Equation

Assets = Liabilities + Shareholders Equity

Accounting Equation is based on the double-entry bookkeeping system, which means that all assets should be equal to all liabilities in the book of accounts. All the entries which are made to the debit side of a balance sheet should have a corresponding credit entry in the balance sheet. Thus it is also known as the balance sheet equationBalance Sheet EquationBalance Sheet Formula is a fundamental accounting equation which mentions that, for a business, the sum of its owner’s equity & the total liabilities equal to its total assets, i.e., Assets = Equity + Liabilitiesread more.

Accounting Equation

Basic Accounting Equation

Assets = Liabilities + Shareholders Equity

Breaking down the Equation

Hence, the total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more should always be equal to the total liabilities in a balance sheet, which fundamental forms the basis of the whole accounting system of any company when it follows the double-entry bookkeeping system.

Example #1

On December 1, 2007, Kartik started his business FastTrack Movers and Packers. The first transaction that Kartik will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of FastTrack Movers & Packers common stock. There are no revenues because the company earned no delivery fees on December 1, and there were no expenses. How will this transaction get recorded in the balance sheet?

Cash & Common Stocks

Accounting Case Study - 5

Example #2

The concept of a double-entry bookkeeping system helps us understand the flow of any particular transaction from the source to the end. Let’s take another basic, expanded accounting equation example.

When there is a purchase of an asset in a company, the purchase amount should also be withdrawn from some account in the company (generally Cash account). Hence, the account from where the amount is withdrawn gets credited, and there needs to be an account debited for the asset purchased (the account which relates to the asset purchased gets debited).

Consider the below entries:

  • On December 27, Joe started with a new company by investing $15,000 as equity in the same.
  • On January 3, Joe purchased an office table for his company, which cost him $5,000.
  • He paid wages to his labor on January 5, totaling $15,000.
  • On January 10, he received a contract from his clients, and they paid him $2,000.
  • On January 13, Joe received another contract for which the client paid $4,000 in advance.
  • On January 15, he completed the service contract that was received on January 13, and the client paid the remaining amount of $8,000.

The Journal entries for the above transactions are as below:

DateAccount DescriptionDebitCredit
27-DecCash$15,000
Shareholders Equity$15,000
3-JanOffice Table$5,000
Cash$5,000
5-JanWages Expense$15,000
Cash$15,000
10-JanCash$2,000
Service Revenue$2,000
13-JanCash$4,000
Accounts Receivables$8,000
Service Revenue$12,000
15-JanCash$8,000
Account Receivables$8,000
Total$57,000$57,000

The corresponding entries in a balance sheet as of January 15 should be as below:

AssetsAmountLiabilitiesAmount
Cash$9,000Service Revenue$14,000
Furniture A/C$5,000
Total$14,000Total$14,000

It is seen that the total credit amount equals the total debt amount. It is the fundamental of the double-entry bookkeeping system of accounting, which helps us understand from the illustration above that total assets should be equal to total liabilities.

In this illustration, Assets are – Cash, Furniture A/C, and Accounts ReceivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more; Liabilities are Wages Expense and Service Revenue.

If we refer to any balance sheet, we can realize that the assets and liabilities, along with the shareholder’s equity, are represented as of a particular date and time. Hence, as of January 15, only 3 accounts exist with a balance – Cash, Furniture A/C, and Service Revenue (the rest get net off during the period of the whole transaction by January 15). Only those accounts which exist with a balance (positive or negative) as on a particular date get reflected on the balance sheet.

Alternatively, we can also understand that total liabilities can be derived if the only asset value is mentioned, and the owner’s equity can also be determined if total assets and total liabilities are available. The basic accounting equation formula can also be used as below:

Total Liabilities = Total Assets – Shareholders Equity

Shareholders Equity = Total Assets – Total Liabilities

Hence, this forms the basis of a lot of analysis to market investors, financial analysts, research analystsResearch AnalystsResearch analyst is a profession where the main task includes research on specific fields, analyzing the facts and figures, interpreting the analysis, and finally presenting the same to a structured audience that can relate to marketing, finance, operations.read more, and other financial institutions.

Accounting equation in an Income Statement

Not only does the balance sheet reflect the basic accounting equation as implemented, but also the income statement.

Final Thoughts

It is understood that the double-entry book-entry accounting system is followed globally and adheres to the rules of debitRules Of DebitDebit is an entry in the books of accounts, which either increases the assets or decreases the liabilities. According to the double-entry system, the total debits should always be equal to the total credits.read more and credit entries. These entries should tally to each other at the end of a particular period, and if there is a gap in total balances, then it needs to be investigated. This system makes accounting a lot easier, by making us create a relationship between the expense/liability and cause of expense/liability (or income/asset and source of income/asset). We need to understand the underlying concept and thumb rule of accountingRule Of AccountingAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. read more, which relates to debit and credit entries at the root level. Thus, although the accounting equation formula seems like a one-liner, it contains a lot of meaning to it and can be explored deeper with complex expense entries as well.

Accounting Equation Video

 

This article has been a guide to the Accounting Equation and its definition. Here we discuss the accounting equation in detail, breaking it down along with practical examples. You may also have a look at the following basic accounting articles for gaining further knowledge –