The accounting equation is the foundation of accounting and the double entry system. The whole of financial accounting is based on this concept.
ASSETS = CAPITAL + LIABILITIES
ASSETS = OWNER’S EQUITY + LIABILITIES
ASSETS = SHAREHOLDER’S EQUITY + LIABILITIES (Corporations)
Assets are the resources that are in the business for use or what the business owns. Assets can include bank, cash, accounts receivable, inventory, prepayments, investments, land, vehicles, buildings, equipment, etc. The asset figure in the basic accounting equation will show the combined amount of all the business’s assets.
Owner’s equity is the amount of those resources that have been supplied by the owners of the business. It represents the claim that the owner has against the assets of the business or the owner’s share of those assets. It will also include the cumulative net income of the business that has not been distributed to the owners of the business.
Liabilities will arise if people other than the owners of the business have supplied some of the resources/assets. Liability is the term used to describe amounts owing to other people for these assets. It represents their claim of the assets of the business. For instance, if the business owner obtains a loan to acquire some of the assets for his business, then a liability will arise. Liabilities represent amounts owed by the business to others or the business’s obligations. Liabilities can include loans, bank overdrafts, accounts payables, amounts owing for expenses, etc
As we are looking at the same thing from two different sides or two different viewpoints, the accounting equation should always balance. The two sides of the equation should have the same total figures. The balance is maintained because every transaction will affect at least two accounts. This should always be the case regardless of the number of transactions that the business undertakes. Therefore, the actual assets, liabilities and owner’s equity may change, but the total of the assets should always equal the combined total of liabilities and owner’s equity.
In the above example we can see that the business owner has just started his business and deposited $5,000 of his own money into his new business bank account. As a result he now has an asset – cash at bank – that being the money he has just deposited into the account. On the other side of the equation, owner’s equity will increase by $5,000 because the owner has provided the full $5,000 himself and as a result has full claim of that asset.
Here we can see that the business owner purchased a computer for $3,000 for his business. Rather than buying it using credit, he has decided to pay by cheque meaning that it will affect the balance of his bank account. It will also lead to a new asset account, computers or office equipment. In the above example it is just called computers.
On the asset side of the accounting equation we can see an increase of $3,000 in the computer account – being the computer the business owner just purchased. We can also see a decrease in the bank balance of $5,000, which was the original amount deposited by the owner. This $5,000 is reduced by the cheque amount, which is the cost of the computer – $3,000. This leaves a balance of $2,000 in the business bank account.
As you can see the amount of the individual assets accounts (Bank, Computer) have changed, but the overall combined total of the asset accounts remains the same. There is no change in owner’s equity and liabilities.
In our final example, the business owner purchases inventory for his business worth $500. He makes this purchase on credit, which means that he does not pay the supplier straight away for these goods. As a result you will see an additional account on the asset side for inventory/stock. This account will have a balance of $500, representing the cost of the stock just purchased.
On the liability side of the accounting equation we will have an account for trade/account payables. This will represent the amount that the business owner owes to the supplier for the stock he has just purchased from the supplier – which is $500.
As you can see, the combined total of the asset accounts has increased by $500 to equal $5,500 but the other side of the equation – owner’s equity and liabilities has also increased by $500 to equal $5,500.
It can be seen that both sides of the accounting equation will have the same totals because we are looking at the same thing but from two different viewpoints. These will equal each other no matter how many transactions the business undertakes.
The actual assets, owner’s equity and liabilities may change but the total of the assets will always equal the total of owners equity plus liabilities.
For more examples, check out the slides below:
If you’re still unsure of applying the Accounting Equation, take a look at the video below:
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