Accounting Equation Definition
Accounting Equation states that sum of the total liabilities and the owner’s capital is equal to the company’s total assets and it is one of the most fundamental parts of the accounting on which the whole double entry system of accounting is based.
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 equation.
Basic Accounting Equation
Breaking down the Equation
- Assets: This is the value of the items that a company owns, they may be tangible or intangible but belong to the company.
- A liability: This is a term for the total value that a company is required to pay in the short term or the long term.
- Shareholders’ Equity: Shareholder’s Equity is the amount of money a company has raised through its issue of shares. Alternatively, it is also the amount of retained earnings of a company. As the shareholders invest their money in the company, they are required to be paid with some amount of returns, which is why this is a liability in the company’s account books.
Hence, the total assets 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.
On December 1, 2007, Kartik starts 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 no delivery fees were earned by the company on 1st December, and there were no expenses. How will this transaction get recorded in the balance sheet?
Cash & Common Stocks
- Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset)
- Retained Earnings will increase when the corporation earns a profit and there will be a decrease when the corporation has a net loss
- Core link between a company’s balance sheet and income statement
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 amount to purchase should also be withdrawn from some account in the company (generally the 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 Dec 27, Joe started with a new company by investing $15,000 as equity in the same.
- On Jan 3, Joe purchased an office table for his company which cost him $5,000.
- He paid wages to his labor on Jan 5 totaling $15,000.
- On Jan 10, he received a contract from his clients, and they paid him $2,000.
- On Jan 13, Joe received another contract for which the client paid $4,000 in advance.
- On Jan 15, he completed the service contract that was received on Jan 13, and the remaining amount of $8,000 was paid by the client.
The Journal entries for the above transactions are as below:
The corresponding entries in a balance sheet as of Jan 15 should be as below:
It is seen that the total credit amount equals the total debt amount. This 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 Receivable; 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 Jan 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 Jan 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:
Hence, this forms the basis of a lot of analysis to market investors, financial analysts, research analysts, and other financial institutions.
Accounting equation in an Income Statement
- An income statement is prepared to reflect the company’s total expenses and total income to calculate the net income to be used for further purposes. This statement is also prepared in the same conjunction as the balance sheet, however, a little differently applied.
- Here, we do not have total assets and liabilities, but the statement is prepared in such a way that if an expense is credited, it will have an equal and opposite entry in debt in a related ledger account.
- The income statement includes the accounts which directly refer to a company’s income or expense like Cost of Goods Sold, Tax expenses, and Interest Payable expenses.
It is understood that the double-entry book-entry accounting system is followed globally and adheres to the rules of debit 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 accounting 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 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 –