The accounting equation is the base of the “Double Entry Book Keeping System.” The equation indicates the relation between the means owned and resources owned by the business. The definition of accounting equation with the principle of “equality” duly finds its effect on the balance sheet with the “Asset Side” being a sum total of “Liabilities and Shareholder’s Equity. This is a clear indication of the “two-fold effect” as in the double-entry system stating that “For every debit, there is an equal amount of credit.” The accounting equation is the primary concept for preparing all financial statements based on journal entries.
The accounting equation formula is expressed in the algebraic form as:
A – L = C
A – L = S
A = Assets of the Entity (What the business owns)
L = Liabilities of the entity (Outsider’s Claims, i.e., what the business owes to outsiders)
C or S = Capital of the Entity (Owner’s/Shareholder’s Claims, i.e., Capital + Net Profit/Loss – Dividends)
The accounting equation indicates that the total assets of the business are being financed from either borrowed money (liabilities) or from owner’s funds/shareholder’s money (Capital + Retained Earnings), or by reduction of existing assets.
This basic accounting equation can also be expressed as:
Liabilities = Assets – Shareholder Equity
Shareholder Equity = Assets – Liabilities
Accounting Equation Example
The accounting equation shows that “Asset” can be purchased from “assets” or from “Liabilities,” i.e., outside borrowing or from “Owner’s Equity / Shareholder’s Equity,” i.e., For purchasing a machine of $3000, one can use cash (Asset) or buy it from borrowing the money from someone (Liability) or from owner’s funds (Capital/Shareholder’s Equity).
Similarly, to pay a liability of $2000, one can use some other debt (Liability) or can use some Asset (Cash or Stock) or pay it off from retained profits (Owner’s Equity).
The below table would help in explaining the basic accounting equation clearly:
|Bringing Capital of $800 to a newly started business in the form of cash/machine/assets||+||800||+||800|
|Buying Stock/goods of $500 from the market on credit||+||500||+||500|
|Selling stock of $300 and using this income to pay off the market credit to that extent.||?||300||?||300|
|Buying a machine of $400 by making a cash payment of 50% and borrowing 50% of the amount. (Asset entry shows machine addition of $400 and cash reduction of $200)||+||200||+||200|
|Earning income, say interest income of $50||+||50||+||50|
|Paying expenses of $100||?||100||?||100|
|Recording expenses but not paying them at the moment||+||100||?||100|
|Paying off the borrowed amount of $200 by cash or cheque||?||200||?||200|
|Receiving cash of $1000 for the sale of a car||0||0||0|
The above examples highlight that the accounting equation holds and remains true for every transaction. Here, we have used the plus sign for indication addition and the minus sign for showing the reduction; however, in the double-entry system of book-keeping, the reduction and increase are shown by recording debits and credits.