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What is the Fundamental Accounting Equation?
The fundamental accounting equation seeks to explain the relationship between the assets constituting a business and the funds that have been used to finance their purchase. Also known as the balance sheet equation, it forms the basis of double entry system of bookkeeping.
As per the Fundamental Accounting Equation,
Assets = Liabilities + Owners Equity
The underlying rationale behind the fundamental accounting equation is that of equilibrium. Meaning, every plus should have a corresponding minus and every debit should have a corresponding credit.
The entire concept of the fundamental accounting equation is contained within the below mentioned three variables. Namely,
- Liabilities &
- Owner’s Equity
The fundamental accounting equation explains that the value of a company’s assets will always be equal to the sum of the borrowed funds and own funds. Also, Given any two variables, the third variable can be easily obtained. The fundamental accounting equation also forms the basis of the balance sheet and profit & loss account. Any transaction in a business, will without a doubt, impact one of the three variables. Therefore, it is important to understand the context of each variable.
Elements of the Fundamental Accounting Equation
Assets represent the economic resources of the entity deployed to generate future income. They can be fixed assets held by the entity for a considerable period of time and used year after year. Examples include land, machinery computers etc. There are also current assets forming a part of the working capital of the company. These assets keep on changing form from asset to money and back in the ordinary course of work. Examples include stock, receivables, advance payments etc. Lastly, there also exists a class of assets called the intangibles. They refer to assets such as goodwill, patents, copyrights & trademarks. Though not tangible, these assets bring huge value to an organization.
It represents the owner’s own investment into the business. Extending from the fundamental accounting equation, the owner’s equity equals the total assets held as reduced by the external liabilities (Assets – Liabilities). For this reason, it is also referred to as Net Assets. All adjustments for profits, reserves, and drawings reflect in this account.
Liabilities refer to the amount a business owes to the outsiders. They can also be classified and current and non-current borrowings. Non-current debt refers to the long-term obligation payable within a period of not less than 12 months. They are generally for financing projects with longer maturities. Current borrowings refers to the short-term obligation a company has to take on in the regular course of business. For example, buyer’s credit for the purchase of a stock or a bank overdraft. Mathematically, Liabilities equals the difference between total assets and owner’s equity (Total Assets – Equity).
Breaking Down Fundamental Accounting Equation
The fundamental accounting equation involves playing around with the balance sheet. Let us divide the balance sheet into four quadrants for a better understanding of the concept.
Owners Equity consists of Reserves and provisions in addition to Share Capital
It consists of Long Term and short-term liabilities.
Comprising of Fixed assets forming required to carry on a business.
Current assets are further broken down into its sub-components for the sake of easier understanding.
Let us now discuss some sample transactions forming a part of the day to day business activities. Pay close attention to how movement within the quadrants takes place.
John has just started a restaurant business. He had some money he had saved throughout the years. He utilized a part of this savings for the purchase of small premises that would serve as his restaurant and kitchen equipment such as ovens and freezers. The balance savings was also introduced to the business as his capital. He continued to hold this amount in his bank.
Let us now test the fundamental accounting equation.
|Owner’s Equity $100,000||+||Nil||=||Building Premises$100,000|
Kitchen Equipment $25,000
Cash in Bank $125,000
The operations of the restaurant commenced and John started entertaining a healthy customers base. To boost his working capital, John decided to now purchase goods on credit. He, therefore, opened a credit account with his vendor, Swiss Dairy from whom he regularly purchased cheese, bread, eggs and other items used every day in his produce. He placed a credit order of $5000 with his vendor.
We can now see a movement from quadrant 2 to 4. The validity of the fundamental accounting equation is verified as below.
|Nil||+||Current Liability $5,000||=||Current Asset (Stock) $5,000|
John’s restaurant has now become a favorite with his customers. However, his customer base is spread far and wide. Therefore, to be able to serve them better, John decides to commence free home delivery. For this purpose, he decides to purchase a van with the bank balance he has on hand.
As is seen above, the flow of the transaction is not across but within the same side. Such transactions also you can easily account for. The equation would look like follows:
Cash (-) $25,000
Fixed Assets (+) $25,000
John sees that his liquid cash balances have started to reduce because of ongoing business. Therefore, as a precautionary measure, he decides to borrow a loan from a financial institution to maintain a buffer of funds. He borrows an amount equal to $300,000. The interest is payable at the rate of 10%. Let us see how the following transaction will play out.
The borrowing of $300,00 is not utilized towards the purchase of any asset or spend. Therefore, it will lead to a corresponding increase in the bank balance. Secondly, the interest payable reduces the cash balance. Conversely, the corresponding entry will be passed in the owner’s equity account. The interest payable would be routed through the P&L account where it is recorded as an expense. In absence of any other transactions, the interest would reduce the profits and consequently the owner’s equity.
The accounting equation representation of the same would be as follows.
|Interest Expense ($30,000)||+||Long Term Borrowing $300,000||=||Cash|
(+) Proceed from loan $300,000
(-) Interest Paid ($30,000)
To summarize, let us plot all the transaction on a single accounting equation to get a holistic view. In order to check the accuracy of calculations, one has to always ensure that the sum total of both sides of the equation always tally.
|Share Capital $250,000||Long-term Loans $300,000||Building $100,000|
|Less Interest Paid ($30,000)||Non-Current Loans $5,000||Kitchen Equipment $25,000|