Understanding the Accounting Equation: Assets = Liabilities + Equity

Meaning of Accounting Equation 

The accounting equation is a principle in accounting that says that a company’s assets must be equal to its liabilities and equity. Where did this equation come from in 1494 an Italian mathematician luca Pacioli formulated this accounting equation based on mathematic equation LHS (left hand side) = RHS (right hand side). 

Represents the relationship between the assets are a company’s resources; liabilities are a company’s obligations and capital of a business owner’s equity or stockholders’ equity.

Accounting equation is a mathematical expression which shows that the assets and liabilities of a firm are equal.

Assets = Liabilities + Capital (Equity)

Based on double entry bookkeeping principle where every transaction has a dual effect on the financial statements. States that a company’s total assets are equal to the sum of liabilities and its shareholders equity.

Accounting equation is also known as basic accounting equation or balance sheet equation.

Accounting equation is the foundation of double entry accounting system; every transaction has two effects Debit = Credit so it ensures that balance sheet remains balanced.  No matter what happens in a business this accounting equation will always hold its place.

Accounting Equation Formula 

1. Asset – Capital – Liabilities = 0 (also known as basic or fundamental accounting equation, balance sheet equation)
2. Asset = Capital + Liabilities (This balance sheet equation tells you that all the assets owned by the business are either sponsored using the owner’s equity or the amount which company should owe other like suppliers (creditors) or loans
3. Capital = Assets – Liabilities (This equation reveals the value of assets owned purely by owner equity. While trying to do this correlation, we can note that incomes or gains will increase owner’s equity and expenses, or losses will reduce it.
4. Liabilities = Assets – Capital (the difference of assets and owner’s investment into business is your liabilities which you owe others in the form of payables to suppliers, banks etc.

Rules of Accounting Equation 

1. Every transaction has two aspects.
2. Increase or decrease in asset will be adjusted from asset
3. Every expense will be deducted from capital and every income will be added to capital 

This fundamental equation is the foundation of double entry bookkeeping

1. Assets are what a company owns
2. Liabilities are what it owes
3. Owner’s equity is the owner’s investment in the business.

1. Assets: All property owned by the company. These are the assets to the business - cash, stock, furniture, debtors, shares, prepaid expenses, accrued income, building, machinery, computer, investment etc if assets added to the business must be debited and if assets reducing from the business must credited in books.
• Cash: The most liquid account. This includes all cash and cash equivalents. 
• Accounts Receivable: The balance of revenue still on credit, net of any allowances for doubtful accounts. In other words, this is what customers owe the company.
• Inventory: This account includes raw materials, work-in-progress (WIP) and finished goods. When a sale is reported, the cost of the sale pulls from this account and is reported under cost of goods sold on the income statement. 
• PP&E: Tangible fixed assets listed net of accumulated depreciation e.g., land, buildings, equipment. 
• Intangible Assets: Examples of identifiable intangible assets include patents and licenses. Examples of unidentifiable intangible assets include goodwill and the company’s brand. 
2. Liabilities: All debts the company currently has outstanding. Creditors, outstanding expenses, bank loan, unearned income (advance income) etc. if liabilities increase in the business its debited and if liabilities decrease from the business must be debited in the books. 
• Accounts Payable: Sums the company owes its vendors and suppliers for items and / or services purchased on credit. 
• Notes Payable: The equivalent of debt. You can have both short- and long-term notes payable (short-term debt is due within one year’s time). 
• Debt: A loan from a bank, for example. 
3. Stockholders’ Equity: Ownership interest in the company after all debts or liabilities have been repaid. it is the residual interest in the total assets of the entity after deducting all its liabilities. It is the claim of owners in the total assets.
• Contributed Capital: Value of the capital that shareholders have contributed (invested) in the company. 
• Retained Earnings: The amount of net income that is retained by the business. 

Process of Accounting Equation 

1. Step 1 – Analyse the transaction to ascertain to which variable of accounting equation it affects by using CLEAR.
2. Sept 2 – Decide the effect of transaction on components of accounting equation i.e., whether they will increase if decrease assets, liability and capital.
3. Step 3 – Finally, record the effect on accounting equation in monetary terms 

Note 

1. C – Capital (Capital + Revenue – Expense)
2. L – Liability
3. E – Expenses & Losses
4. A – Assets 
5. R – Revenue or Income or Profit

Format of accounting equation

Accounting Equation 

Serial No.	Transaction	Assets                                                   =   Liabilities + Capital

Accounting Equation examples 

Transaction	Assets	=	Liabilities + Capital
	Cash + Stock	=	Creditors + Capital
Started business with cash Rs. 1,00,000	1,00,000 + 0	=	0 + 1,00,000
Purchased goods for cash 30,000	-30,000 + 30,000	=	0 + 0
New Equation	70,000 + 30,000	=	0 + 1,00,000
Purchased goods on credit 40,000	0 + 40,000	=	40,000 + 0
Paid Salaries 20,000	-20,000 + 0	=	0 + (-20,000)
New Equation	50,000 + 70,000	=	40,000 + 80,000
Received interest	10,000 + 0	=	0 + 10,000
New Equation	60,000 + 70,000	=	40,000 + 90,000

Balance Sheet

A balance sheet is statement prepared with a view to measure the exact financial position of a business on certain fixed date.

Balance sheet as at 31st March, ….

LIABILITIES	AMOUNT	ASSETS	AMOUNTS

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