Understanding the Accounting Equation

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:  

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 or 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

AccountsAccounts TypeIncrease/Decrease
Cash AssetIncrease
CapitalOwner’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  

AccountsAccounts TypeIncrease/Decrease
Furniture (Table)               AssetIncrease
Cash  AssetDecrease  

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  

AccountsAccounts TypeIncrease/Decrease
Inventory (Goods)               AssetIncrease
A/c Payable (Y Company)  LiabilitiesIncrease  

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  

AccountsAccounts TypeIncrease/Decrease
Salaries Expenses                 Owner’s Equity           Decrease
CashAssetDecrease  

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  

AccountsAccounts TypeIncrease/Decrease
Accounts Receivable              AssetIncrease  
CashAssetIncrease  
Service revenue                     Owner’s EquityIncrease  

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  

AccountsAccounts TypeIncrease/Decrease
Accounts Receivable              AssetDecrease  
CashAssetIncrease  

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  

AccountsAccounts TypeIncrease/Decrease
Wages Expenses                      Owner’s EquityDecrease  
Wages Payable                        LiabilitiesIncrease  

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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