Summary:

The equation that is the foundation of double entry accounting. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company's shareholders.Thus, the accounting equation is: Assets = Liabilities + Shareholder Equity. The balance sheet is a complex display of this equation, showing that the total assets of a company are equal to the total of liabilities and shareholder equity. Any purchase or sale by an accounting equity has an equal effect on both sides of the equation, or offsetting effects on the same side of the equation. The accounting equation is also written as Liabilities = Assets – Shareholder Equity and Shareholder Equity = Assets – Liabilities.

The three elements of this equation are assets, liabilities, and owner’s equities are the three major sections of the balance sheet.  Through the use of double entry bookkeeping, bookkeepers and accountants ensure that the "balance" always holds (both sides of the equation are always equal). 

The accounting equation has great importance because it reveals the company's financial standing at a particular time. The financial standing is important to investors who may wish or have purchased stock in the business. Also the financial standing of the organization is important to creditors who wish to loan the business money. The company’s goal is to have resources that have no claims in opposition to them.

1. Accounting Equation: The basic accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a business. It is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as

 

In a corporation, capital represents the stockholders' equity. Since every business transaction

affects at least two of a company’s accounts, the accounting equation will always be “in

balance,” meaning the left side should always equal the right side. Thus, the accounting

formula essentially shows what the firm owns (its assets) are purchased by either what it

owes (its liabilities) or by what its owners invest (its shareholders equity or capital).

2   Assets:

Assets are resources owned or controlled by a company. These resources are expected to

yield future benefits. Examples are Web servers for an online services company, musical

instruments for a rock band, and land for a vegetable grower. The term receivable is used to

refer to an asset that promises a future inflow of resources. A company that provides a

service or product on credit is said to have an account receivable from that customer.

Examples of assets

The following items are commonly found in the assets section of the statement of financial

position (balance sheet) of a company:

land and buildings owned by the company

buildings leased by the company on a 50-year lease

plant and machinery owned by the company

equipment leased (rented) by the company under a finance lease

vehicles

raw materials

goods for resale

finished goods

2.1 Current asset:

A current asset is an asset that satisfies any of the following criteria:

(a) It is expected to be realized in, or is intended for sale or consumption in, the entity’s normal operating cycle;(b) It is held primarily for the purpose of being traded;(c) It is expected to be realized within 12 months after the reporting period;(d) It is cash or a cash equivalent.3

2.2 Non-current asset:

A non-current asset is any asset that does not meet the definition of a current asset.Non-current assets include tangible, intangible and financial assets of a long-term nature. These are also described as fixed assets.

3 Liability:

A liability is defined as: ‘a present obligation of the entity arising from past events, the Settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’ this wording reads some what tortuously but has been designed to mirror the definition of an asset.

Examples of liabilities:

Here is a list of items commonly found in the liabilities section of the statements ofFinancial position (balance sheets) of companies:

Bank loans and overdrafts Trade payables (amounts due to suppliers of goods and services on credit terms) Taxation payable Accruals (amounts owing, such as unpaid expenses) Provision for deferred taxation Long-term loans.

3.1 Current liability:

A current liability is a liability which satisfies any of the following criteria:

(a) It is expected to be settled in the entity’s normal operating cycle.(b) It is held primarily for the purpose of being traded.(c) It is due to be settled within 12 months after the reporting period.

3.2 Non-current liability:

A non-current liability is any liability that does not meet the definition of a current liability. Non-current liabilities are also described as long-term liabilities.

4. Equity

Equity is the owner’s claim on assets. Equity is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity. Equity for a non corporate entity commonly called owner’s equity increases and decreases as follows: owner investments and revenues increase equity, whereas owner withdrawals and expenses decrease equity. Owner investments are assets an owner puts into the company and are included under the generic account Owner, Capital. Revenues increase equity and are the assets earned from a company’s earnings activities. Examples are consulting services provided, sales of products, facilities rented to others, and commissions from services. Owner withdrawals are assets an owner takes from the company for personal use. Expenses decrease equity and are the cost of assets or services used to earn revenues.

4.1 Revenue:

Revenue is created by a transaction or event arising during the operations of the business which causes an increase in the ownership interest. It could be due to an increase in cash or trade receivables, received in exchange for goods or services. Depending on the nature of the business, revenue may be described as sales, turnover, fees, commission, royalties or rent.

4.2 Expense:

An expense is caused by a transaction or event arising during the operations of the business which causes a decrease in the ownership interest. It could be due to an outflow or depletion of assets such as cash, inventory (stock) or non-current assets (fixed assets). It could be due to a liability being incurred without a matching asset being acquired.

5 Applications of accounting equation:

The accounting equation is fundamental to the double-entry bookkeeping practice. Its applications in accountancy and economics are thus diverse.

5.1 Financial Statements:

A company’s quarterly and annual reports are basically derived directly from the accounting equations used in bookkeeping practices. These equations, entered in a business’s general ledger, will provide the material that eventually makes up the foundation of a business’s financial statements. This includes expense reports, cash flow, interest and loan payments, salaries, and company investments.

5.2 Double Entry Bookkeeping System:

The accounting equation plays a significant role as the foundation of the double entry bookkeeping system. This accounting system ensures that a company’s accounts are always balanced and that all financial transactions are documented in detail. The primary aim of the double entry system is to keep track of debits and credits, and ensure that the sum of these always matches up to the company assets, a calculation carried out by the accounting equation.

5.3 Income and Retained Earnings:

Use of the accounting equation is also an essential component in computing, understanding, and analyzing a firm’s income statement. This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly. Thus, the accounting equation is an essential step in determining company profitability.

5.4 Company Worth:

Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets.

5.5 Investments:

Due to its role in determining a firm’s net worth, the accounting equation is an important tool for investors looking to measure a company’s holdings and debts at any particular time, and frequent calculations can indicate how steady or erratic a business’s financial dealings might be. This provides valuable information to creditors or banks that might be considering a loan application or investment in the company.

6 Expanded Accounting Equation:

The expanded Accounting Equation using all five types of accounting elements is:

Assets + Expenses = Equity + Revenue + Liability

One might also see it in other forms using other domain-specific terminology:

1. Assets = Liabilities + Stockholders' Equity2. Assets = Liabilities + Common Stock + Retained Earnings3. Assets = Liabilities + Capital - Drawing + Revenue - Expenses4. Assets = Liabilities + Common Stock + Net Income - Dividends5. Assets = Liabilities + Common Stock + Income - Expenses - Dividends

7 Balance Sheet:

An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity, as well as totals to ensure that it balances.

8 Advantages of accounting equation:

The advantages of accounting equation are as follows:

1. It shows owner's equity, outsiders' equity and assets. If two things are given the other can be known by applying the equation.

2. Accounting equation reveals the success or failure of a business. If owner's equity decreases, it implies failure and in reverse case there is success.

3. It shows the impact of each transaction on owner's equity, liability and assets.

4. Accounting equation if presented item wise, it helps to calculate various ratios such as, capital to total assets, liability to total assets, current assets to fixed assets, current liability to current assets etc. which help a lot in taking important decisions.

9 Use of Accounting Equation:

The following examples are given to prove the accounting equation:

1. Services Provided for Cash and Credit: Soft byte provides Tk. 3,500 of

programming services for customers. The company receives cash of Tk. 1,500 from

customers, and it bills the balance of Tk. 2,000 on account. This transaction results in an

equal increase in assets and owner’s equity. Three specific items are affected: Cash

increases Tk. 1,500; Accounts Receivable increases Tk. 2,000; and Mr. Karim, Capital

increases Tk. 3,500. The new balances are as follows:

Assets = Liabilities + Owner’s Equity

Cash +Accounts Rec. + Supplies + Equipment = Accounts + Mr. KarimPayable + Capital

Tk. 9,200+ 1,600+ 7,000 Tk. 1,850 Tk. 15,950 +Tk. 1,500+2,000 +3,500 Tk. 10,700+2,000+1,600+7,000 = Tk. 1,850 + Tk19,450

Tk.21,300 Tk. 21,300

2. Payment of Expenses: Soft byte pays the following expenses in cash for September:

store rent Tk. 600, salaries of employees Tk. 900, and utilities Tk. 200. These payments

result in an equal decrease in assets and owner’s equity. Cash decreases Tk. 1,700 and

Mr. Rahim, Capital decreases by the same amount. The effect of the payments on the

equation is:

Assets = Liabilities + Owner’s EquityCash +Accounts Rec. + Supplies + Equipment = Accounts Mr Rahim

Payable + CapitalTk. 10,700+2,000+1,600+7,000 Tk. 1,850 Tk19,450

-Tk. 1,700 - 600 - 900

= + - 200Tk. 9,000+2,000+1,600+7,000 Tk. 1,850 Tk17,750

Tk. 19,600 Tk. 19,600

3. Payment of Accounts Payable: Soft byte pays its Tk. 250 Daily News bill in cash.

The company previously recoded the bill as an increase in Accounts Payable and a

decrease in owner’s equity. This payment “on account” decreases the asset Cash by Tk.

250 and decreases the liability Accounts Payable by Tk. 250. The effect of this

transaction on the equation is:

Assets = Liabilities + Owner’s EquityCash +Accounts Rec. + Supplies + Equipment = Accounts Mr. Rahim

Payable + Capital

Tk. 9,000+2,000+1,600+7,000 Tk. 1,850 Tk.17,750-Tk. 250 = -250 +Tk. 8,750+2,000+1,600+7,000 Tk. 1,600 Tk.17,750

Tk. 19,350 Tk. 19,350

4. Receipt of Cash on Account: Soft byte receives tk. 600 in cash from customers who

had been billed for services. This does not change total assets, but it changes the

composition of those assets. Cash increases tk. 600 and Accounts Receivable decreases

tk. 600. The new balances are:

Assets = Liabilities + Owner’s EquityCash +Accounts Rec. + Supplies + Equipment = Accounts Mr. Rahim,

Payable + CapitalTk. 8,750+2,000+1,600+7,000 Tk. 1,600 Tk.17,750+Tk. 600-600 = +Tk. 9,350+1,400+1,600+7,000 Tk. 1,600 Tk.17,750

Tk. 19,350 Tk. 19,350

5. Withdrawal of Cash by Owner: Mr. Rahman withdraws Tk. 1,300 in cash from the

business for his personal use. This transaction results in an equal decrease in assets and

owner’s equity. Both Cash and Mr. Rahman Capital decreases Tk. 1,300, as shown

below:

Assets = Liabilities + Owner’s EquityCash +Accounts Rec. + Supplies + Equipment = Accounts Mr. Rahman

Payable + Capital

Tk. 9,350+2,000+1,600+7,000 Tk. 1,600 Tk.17,750 -Tk. 1,300 = + - 1,300 Tk. 8,050+1,400+1,600+7,000 Tk. 1,600 Tk.16,450

Tk. 18,050 Tk. 18,050

6. Investment by Owner: Suppose Mr. Karim invests Tk. 15,000 cash in the business.

This transaction results in an increase in assets and owner’s equity. The asset cash

increases Tk. 15,000, as does the owner’s equity, identified as Mr. Karim Capital. The

effect of the transaction on the basic equation is:

Assets = Liabilities + Owner’s EquityCash = Mr. Karim, Capital

+Tk. 15,000 = +Tk. 15,000

7. Purchase of Equipment for Cash: Soft byte purchases computer equipment for Tk

7,000 cash. This transaction results in an equal increase and decrease in total assets,

though the composition of assets changes: Cash decreases Tk 7, 000, and the asset

Equipment increases Tk. 7,000. The specific effect of this transaction and the cumulative

effect of the first two transactions are :

Assets = Liabilities + Owner’s Equity Cash + Equipment = Mr. Rahman CapitalTk. 15000 Tk. 15,000-Tk. 7,000+ 7,000Tk. 8,000 Tk.7, 000 = Tk. 15,000

Tk. 15,000

8. Purchase of Supplies on Credit: Softbyte purchases for Tk. 1,600 from Acme Supply

company computer paper and other supplies. This transaction is a purchase on account.

Assets increase because of the expected future benefits of using the paper and supplies,

and liabilities increase by the amount due Acme Company. The asset supplies increase

Tk. 1,600, and the liability Accounts Payable increase by the same amount. The effect on

the equation is:

Assets = Liabilities + Owner’s EquityCash + Supplies + Equipment = Accounts Payable +Mr. Rahim CapitalTk. 8,000 Tk. 7,000 Tk. 15,000 +Tk. 1,600 +Tk. 1,600Tk. 8,000 + 1,600 + 7,000 = Tk. 1,600 + Tk. 15,000

Tk. 16,600 Tk. 16,600

9. Services Provided for Cash: Softbyte receive Tk. 1,200 cash from customers for

programming services it has provided. This transaction represents Softbyte’s principal

revenue-producing activity. Recall that revenue increases owner’s equity. In this

transaction, Cash increases Tk. 1,200, and Mr. Rahim, Capital increases Tk. 1,200. The

new balances in the equation are:

Assets = Liabilities + Owner’s EquityCash + Supplies + Equipment = Accounts Payable + Mr.Rahim,CapitalTk. 8,000+1,600+7,000 Tk. 1,600 Tk. 15,000

+Tk. 1,200 +1,200Tk. 9,200+1,600+7,000 = Tk. 1,600 + Tk. 16,200

Tk. 17,800 Tk. 17,800

10. Purchase of Advertising on Credit: Softbyte receives a bill for Tk. 250from the

Daily News for advertising but postpones payment until a later date. This transaction

results in an increase in liabilities and a decrease in owner’s equity. The specific items

involved are Accounts Payable and Mr. Rahim Capital. The effect on the equation is:

Assets = Liabilities + Owner’s EquityCash + Supplies + Equipment = Accounts Payable + Mr. Rahim CapitalTk. 9,200+1,600+7,000 Tk. 1,600 Tk. 16,200

+Tk. 250 -250Tk. 9,200+1,600+7,000 Tk. 1,850 Tk. 15,950

Tk. 17,800 Tk. 17,800

10 Conclusions:

Business Transactions occur on a daily basis as a result of doing business. Items are

purchased or sold, credit is extended or borrowed, income is made or expenses are

assumed. These business transactions result in changes to the three elements of the basic

accounting equation.

1. A transaction that increases total assets must also increase total liabilities

or owner’s equity.

2. A transaction that decreases total assets must also decrease total liabilities

or owner’s equity.

3. Some transactions may increase one account and decrease another on the

same side of the equation i.e. one asset increases and another decreases.

Transaction Analysis is the process of reconciling the differences made to each side of

the equation with each financial transaction occurs. Let’s look at some sample

transactions to get a better understanding of how the analysis and equation work.

11 References:

1. http://www.google.com.bd/#q=benefits+of+accounting+equation&psj=1&ei=2Wx_Ufn3A4rRrQff9oGQAQ&start=10&sa=N&bav=on.2,or.r_qf.&fp=397bd23770Meigs and Meigs. Financial Accounting, Fourth Edition. McGraw-Hill, 1983.

2. Accounting equation explanation with examples, accountingcoach.com.3.4. Libby, Libby, and Short. Financial Accounting, Third Edition. McGraw-Hill,

2001.

5. http://www.investopedia.com/terms/a/accounting-equation.asp

6. http://www.publishyourarticles.net/knowledge-hub/accounting/what-are-the-

advantages-of-accounting-equation.html

7. http://bizfinance.about.com/od/accountingpractices/a/Accounting_Equation.htm

8. 057352&biw=1024&b

9. http://en.wikipedia.org/wiki/Accounting_equation