Understanding the Accounting Equation [Notes with PDF]

In this article, we will learn in-depth about the accounting equation, including its definition, basic and expanded accounting equations, examples, uses, and much more.

What is the Accounting Equation?

In a given time, the total assets should be equal to the sum of the liabilities and the equity of the owner. The equation that represents this basic framework is called the Accounting Equation.

Here we will learn

1. Basic Accounting Equation
2. Expanded Accounting Equation
3. Accounting Equation Example

Important Note about Accounting Equation

1. It is applicable to all business transactions.
2. It applies to both small businesses and large corporations.
3. Provides the underlying framework for recording and summarizing business transactions.

Basic Accounting Equation

Formula of the Basic Accounting Equation is given below  

A=L+OE  

Here,

A     = Assets

L     = Liabilities

OE  = Owner’s Equity  

So we can Say,   Assets   =   Liabilities    +    Owner’s Equity

“The relationship of the basic accounting equation is that the assets must be equal to the sum of the liabilities and the equity of the owner.” 

Expanded Accounting Equation

 Assets   =   Liabilities + Owner’s Capital-Owner’s Drawings + Revenues – Expenses

Let’s explain the Assets, Liabilities, and Owner’s Equity to better understand the Accounting Equation.

Assets: 

Assets are the resources the company owns. The company uses its assets to carry out activities such as production and sales.   

The common feature of all assets is the ability to provide future services or benefits. In a business, that service potential or future economic benefit will ultimately result in cash inflows (receipts).

 
Example of Assets:

• Cash and Cash Equivalents
• Accounts Receivable
• Inventory
• Prepaid Expenses
• Plant and Machinery
• Furniture
• Investment
• Land

Liabilities: 

Liabilities are business legal financial debt and obligation against assets. it arises during the business Operation.  

Example of Liabilities:

• Accounts Payable
• Notes Payable
• Accrued Expenses Payable
• Income tax payable
• Loans
• Borrowings
• Bank Draft
• Differed Revenues

Owner’s Equity:  

The owner’s claim on total assets is called the owner’s equity.  

1. Owner’s Equity = total assets – total Liabilities.
2. Owner’s Equity= Owner’s Investment- Owner’s Drawings + Net Profit-Net Loss
3. Owner’s Equity is increased by the Owner’s investment and Business Revenues
4. Owner’s Equity is decreased by the Owner’s Drawings and Business Expenses.

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Examples and Uses of Accounting Equation

Let’s try to understand the practical uses of the accounting equation by taking some examples that will make it clear if there is any blur in your mind.

Let’s start with  Examples of Accounting Equation  

Example-1: Mr X invested cash $18,000 in the business.  

Here involved 2 accounts

Accounts	Accounts Type	Increase/Decrease
Cash	Asset	Increase
Capital	Owner’s Equity	Increase

Impact

Asset	=	Liabilities	+	Owners’ Equity
Cash(+$18,000)	=	0	+	Capital (+ $18,000)

Example-2: Purchase an office table for cash $1,000  

Here involved 2 accounts  

Accounts	Accounts Type	Increase/Decrease
Furniture (Table)	Asset	Increase
Cash	Asset	Decrease

Impact

Asset	=	Liabilities	+	Owners’ Equity
Cash (- $1,000) Furniture (+$1,000)	=	0	+	0

Example-3: Purchase Goods from “Y” Company for $3000 on credit.  

Here involved 2 accounts  

Accounts	Accounts Type	Increase/Decrease
Inventory (Goods)	Asset	Increase
A/c Payable (Y Company)	Liabilities	Increase

Impact

Asset	=	Liabilities	+	Owners’ Equity
Inventory(+$3,000)	=	A/c Payable(+$3,000)	+	0

 Example-4: Salaries paid for cash $2000  

Here involved 2 accounts  

Accounts	Accounts Type	Increase/Decrease
Salaries Expenses	Owner’s Equity	Decrease
Cash	Asset	Decrease

Impact

Asset	=	Liabilities	+	Owners’ Equity
Cash (-$2,000)	=	0	+	Salaries Exp. (-$2,000)

Example-5: Services provided for $4,000 Cash and $5,000 on Credit  

Here involved 3 accounts  

Accounts	Accounts Type	Increase/Decrease
Accounts Receivable	Asset	Increase
Cash	Asset	Increase
Service revenue	Owner’s Equity	Increase

Impact

Asset	=	Liabilities	+	Owners’ Equity
A/c Receivable(+$5,000) Cash (+$4,000)	=	0	+	Service Revenue(+$9,000)

Example-6: Cash $ 1,500 received from Customer.  

Here involved 2 accounts  

Accounts	Accounts Type	Increase/Decrease
Accounts Receivable	Asset	Decrease
Cash	Asset	Increase

Impact

Asset	=	Liabilities	+	Owners’ Equity
A/c Receivable(-$1,500) Cash (+$1,500)	=	0	+	0

Example-7: Wages outstanding for the month of September 2019 $400  

Here involved 2 accounts  

Accounts	Accounts Type	Increase/Decrease
Wages Expenses	Owner’s Equity	Decrease
Wages Payable	Liabilities	Increase

Impact

Asset	=	Liabilities	+	Owners’ Equity
0	=	Wages Payable (+$400)	+	Wages Esp. (-$400)

 If we analyze the above examples of accounting equations, we find that the total assets at any time will be equivalent to the funds mobilized by the company, i.e. Creditors ‘ claims and owners ‘ fairness.

This connection is referred to as the accounting equation or balance sheet, i.e. Assets= liabilities + capital.

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