What is "Accounting Equation"?
The “Accounting Equation” is a basic principle of accounting and a fundamental part of the balance sheet. The equation is:
Assets = Liabilities + Shareholder’s Capital
The equation sets the basis of double-entry accounting and shows the structure of the balance sheet. Double-entry is a system in accounting where each transaction affects both sides of the accounting equation. Each change to an asset account, there shall be an equal change to a related liability or shareholder’s capital account. It is critical to keep the accounting equation in mind when creating journal entries.
The balance sheet has three major sections: Assets, Liabilities, and Shareholder’s Capital:
Here are some items that qualify under each section:
Assets: Cash, Accounts Receivable, Inventory, Equipment
Liabilities: Accounts Payable, Short-term borrowings, Long-term Debt
Shareholder’s Capital: Share Capital, Retained Earnings
This equation shows us the relationship between the above mentioned items.
Transforming the Accounting Equation
The accounting equation can also be transformed or rearranged into this form:
Shareholder’s Capital = Assets - Liabilities
In this form it is easier to showcase the relationship between shareholder’s capital and debt (liabilities). As you can observe, shareholder’s capital is what remains after liabilities have been subtracted from the assets. This is because the creditors - the parties that lend money - have the first claim to the assets of a company.
So for example, if a certain company goes bankrupt, its assets are then sold and these funds are used to first settle any outstanding debts. Only after the debts are settled are the shareholders entitled to any of the remaining company assets to help recover their investments.
But regardless of how the accounting equation is represented, it is critical to remember that the equation must always be in balance.
Accounting Equation Examples
For each transaction, both sides of this equation must have an equal net effect. Here are some examples of transactions and how they affect the accounting equation
1. Equipment Procurement with Cash
Company ABC wishes to procure a $500 machine using only cash. This transaction would then result in a credit to Equipment (+$500) and a debit to Cash (-$500). The net effect on the accounting equation will be as follows:
This transaction affects only the assets side of the equation and therefore there is no matching effect in liabilities or shareholder’s capital on the right side of the equation.
2. Procurement of Machine with Cash and Credit
Company ABC wishes to procure a $500 machine but it only has $250 of cash in its holdings. The company is allowed to buy the machine with an initial payment of $250 but it then owes the manufacturer the remaining amount. This results in a credit to Equipment (+$500) and a credit to Accounts Payable (+$250) and a debit to Cash (-$250). The net effect on the accounting equation will be as follows:
This transaction affects both sides of the accounting equation. Both the left and right sides of the equation increased by +$250