Definition, Explanation and Examples

These are some simple examples, but even the most complicated transactions can be recorded in a similar way. Let’s take a look at the formation of a company to illustrate how the accounting equation works in a business situation. The Accounting Equation is a vital formula to understand and consider when it comes to the financial health of your business. The accounting equation is a factor in almost every aspect of your business accounting.

Introduction to the Accounting Equation

1. Capital can be defined as being the residual interest in the assets of a business after deducting all of its liabilities (ie what would be left if the business sold all of its assets and settled all of its liabilities).
2. This transaction affects both sides of the accounting equation; both the left and right sides of the equation increase by +$250.
3. If the left side of the accounting equation (total assets) increases or decreases, the right side (liabilities and equity) also changes in the same direction to balance the equation.
4. So, as long as you account for everything correctly, the accounting equation will always balance no matter how many transactions are involved.

All assets owned by a business are acquired with the funds supplied either by creditors or by owner(s). In other words, we can say that the value of assets in a business is always equal to the sum of the value of liabilities and owner’s equity. The total dollar amounts of two sides of accounting equation are always equal because they represent two different views of the same thing.

The accounting equation is based on the premise that the sum of a company’s assets is equal to its total liabilities and shareholders’ equity. As a core concept in modern accounting, this provides the basis for keeping a company’s books balanced across a given accounting cycle. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner’s (or stockholders’) equity.

Additional Resources

This is how the accounting equation of Laura’s business looks like after incorporating the effects of all transactions at the end of month 1. In this example, we will see how this accounting equation will transform once we consider the effects of transactions from the first month of Laura’s business. If you’re still unsure why the accounting equation just has to balance, the following example shows how the accounting equation remains in balance even after the effects of several transactions are accounted for. The business has paid $250 cash (asset) to repay some of the loan (liability) resulting in both the cash and loan liability reducing by $250. $10,000 of cash (asset) will be received from the bank but the business must also record an equal amount representing the fact that the loan (liability) will eventually need to be repaid.

Limits of the Accounting Equation

Obligations owed to other companies and people are considered liabilities and can be categorized as current and long-term liabilities. Think of retained earnings as savings, since it represents the total profits that have been saved and put aside (or “retained”) for future use. This number is the sum of total earnings that were not paid to shareholders as dividends. Incorrect classification of an expense how to calculate credit and debit balances in a general ledger does not affect the accounting equation. Cash (asset) will reduce by $10 due to Anushka using the cash belonging to the business to pay for her own personal expense. As this is not really an expense of the business, Anushka is effectively being paid amounts owed to her as the owner of the business (drawings).

Example: How to Calculate the Accounting Equation from Transactions

Due within the year, current liabilities on a balance sheet include accounts payable, wages or payroll payable and taxes payable. Long-term liabilities are usually owed to lending institutions and include notes payable and possibly unearned revenue. The accounting equation states that the amount of assets must be equal to liabilities plus shareholder or owner equity.

This equation holds true for all business activities and transactions. If assets increase, either liabilities or owner’s equity must increase to balance out the equation. In this form, it is easier to what is a topside journal entry highlight the relationship between shareholder’s equity and debt (liabilities). As you can see, shareholder’s equity is the remainder after liabilities have been subtracted from assets. This is because creditors – parties that lend money such as banks – have the first claim to a company’s assets.

The accounting equation is also called the basic accounting equation or the balance sheet equation. Before explaining what this means and why the accounting equation should always balance, let’s review the meaning of the terms assets, liabilities, and owners’ equity. The claims to the assets owned by a business entity are primarily divided into two types – the claims of creditors and the claims of owner of the business.