Accounting Equation Definition, Examples & Explanation

SHARE THIS ARTICLE

The total assets at any point of time will be equal to the funds mobilized by the business i.e. creditors’ claims and owners’ equity this relationship is known as accounting equation or balance sheet equation i.e. assets = liabilities + equity.

To start a business, you need funds in order to acquire assets. There are two main sources of funds, the owner and the creditors. The owners and creditors establish a claim on the business assets to the extent of funds that they provide. The management has to make two important decisions. One is about the composition of these funds, i.e. what should be the ratio of owners funds and creditors’ fund in the total investment at any point of time. This is known as financing decision. The other decision is about the use of these funds i.e. the composition of assets to be acquired from these funds. This refers to the investing decisions.

Accounting Equation Formula 

Below is the formula of basic accounting equation for sole proprietorship

Accounting Equation for Sole Proprietorship

Accounting Equation for corporations

Accounting Equation for Corporations

It is customary to place Liabilities before owners’ equity in the accounting equation creditors have rights to the assets. The residual claim of the owner is sometime given greater emphases by transporting liability to the other side of the equation the formula becomes as below.

Owners / Shareholders’ Equity = Assets – Liabilities

Assets

Assets are economic resources owned by any business and expected to benefit in future. It has the potential to generate revenue. It contributes directly and indirectly to the flow of cash and cash equivalents. Assets can be used for:

  1. Singly or combination with other assets in the production of goods and services to be sold by the enterprise
  2. To exchange for other assets
  3. To settle a liability

Assets having physical form like building, cars, furniture, plants and machinery are tangible assets and examples of intangible assets patent, goodwill and copyright.  Some assets consumers and converted into cash within one operating cycle generally less than a year are known as current assets and some are supposed to generate benefits for a longer period are called long term assets.

Liabilities

Liabilities are known as creditors’ claims on the assets of the company. The company owes to outsiders. It creates obligations on company and results from past transactions or other past events. Some examples for the settlement of liability obligations:

  1. Payment of cash
  2. Transfer of other assets
  3. Provision of services
  4. Replacement of that obligation with another obligation
  5. Conversion of the obligation to equity

Liabilities are generally classified into two groups. Those liabilities which are supposed to be settled within one accounting period are called current liabilities and those settled over a period of one accounting period are long term liabilities. Other examples of liabilities are accounts payable, unearned income, bank loans etc.

Owners / Shareholders’ Equity

Equity is the claim of company owners on assets.  The claim may be rise through investment by owners or by the earning of profit by the company. The owners’ claim is defined as the residual interest in the assets of the company after deducting all its liabilities.

The accounting equation will always remain in balance.

Balance Sheet and Income Statement

The Balance Sheet reports the financial position of an enterprise at a specific point of time. Like accounting equation is has three main section i.e. assets, liabilities and owner / shareholder equity.  Balance Sheet provide the following information at any point of time.

  1. Sources of funds, creditors and owners / shareholders claims
  2. Composition of funds provided by different sources
  3. And how sole owner or company utilized all the assets acquired

Income statement shows the financial performance of company for a specific period of time usually a month or year. It comprises net profit and net loss resulting from business transaction during a period of time. Income earned or expense incurred bother are recorded in the equation as increase or decrease in capital receptively.

Examples of Accounting Equation

Here we will learn how to analyze transaction and how it effects on accounting equation. Its composition will change with each transaction but it will never be an inequality. Here it is important to tell you that every transaction will have two or more impacts.

Transaction 1. Michael Scott is an entrepreneur who wants to start a business Scott Autos (Auto Workshop). He opens a bank account and on April 1, 2016 Scott contributes $50,000. It resulted in an increase in assets and creates owners capital claim on the business.

Assets 
=
Liabilities
+
Owner's Equity
$50,000
 
 
 
$50,000

Below is the general journal entry, let us record the transaction in asset account bank and owners’ equity account, where the asset account bank is increased by $50,000 and owners claim on company assets also increased with the same amount.

Date Account Name Debit  Credit
Apr. 01, 2016
Bank
 
50,000
 
 
 
Scott Capital
 
50,000

Transaction 2. Mr. Scott is a visionary entrepreneur, he purchases. After deciding location of the company he is keen to purchase a building suitable for Scott Autos. On behalf Scott Autos Mr. Scot purchased the building for $20,000 dated April 2, 2016. Find out how this transaction will effect the Scott Autos accounting equation.

Assets
=
Liabilities
+
Owner's Equity
Bank Building      
$50,000
$30,000
$20,000

If you analyze this accounting transaction, you will see that both sides of the equation are the equal. Here one asset account (bank) decreased and one asset account (building) increased. In this transaction just the composition is changed.

This accounting transaction is recorded in asset account and building account. Following is the general journal entry of this business transaction.

Date Account Name Debit  Credit
Apr. 02, 2016
Building
 
20,000
 
 
 
Bank
 
20,000

Transaction 3. Mr. Scott is very happy as he started new business and purchased the building of his choice on very feasible location. On April 2, 2016 Scott purchased office furniture $1,000 on credit from A One furniture. It is not necessary to purchase assets on cash payment. They can be acquired by credit as well. Let us see to this business transaction affect the equation.

Assets
=
Liabilities
+
Owner's Equity
Bank
Building
Furniture
 
$1,000
 
$50,000
$30,000
$20,000
$1,000

Here you can analyze Scott Autos assets increased and liability account created.

This accounting transaction is recorded in asset account and Liability account. Following is the general journal entry of this business transaction.

Date Account Name Debit  Credit
Apr. 02, 2016
Furniture
 
1,000
 
 
 
Accounts Payable
 
1,000

As you analyze all these three transactions that both sides of the accounting equation are balanced. This is the important rule of accounting. It cannot be out of balance and asset account will remain equal liability and owners’ shareholder equity. As per double entry account each transaction is recorded as debits and credits in its appropriate accounts.