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Accounting equation
 Posted in: Introduction to financial accounting (explanations)

By: Rashid Javed | Updated on: December 17th, 2021

Accounting equation describes that the total value of assets of a business entity is always equal
to its liabilities plus owner’s equity. This equation is the foundation of modern double entry system
of accounting being used by small proprietors to large multinational corporations. Other names
used for this equation are balance sheet equation and fundamental or basic accounting equation.

Definition and explanation

We know that every business holds some properties known as assets. 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. In accounting, the claims of creditors are referred to as liabilities
and the claims of owner are referred to as owner’s equity.

Accounting equation is simply an expression of the relationship among assets, liabilities and
owner’s equity in a business. The general form of this equation is presented below:

Assets = Liabilities + Owner’s Equity

Notice that the left hand side (also known as assets side) of the equation shows the resources
owned by the business and the right hand side (also known as equity side) shows the sources of
funds used to acquire these resources. All assets owned by a business are acquired with the funds
supplied either by creditors or by owner. 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.

In accounting equation, the liabilities are normally placed before owner’s equity because the rights
of creditors are always given a priority over the rights of owners. Because of this preference, the
liabilities are sometime transposed to the left side which results in the following form of accounting
equation:

Assets – Liabilities = Owner’s Equity

If dollar amounts of any two of the three elements are known, we can solve the equation to find the
third one. For example, if a business owns total assets amounting to $400,000 and total liabilities
amounting to $120,000, the owners equity must be equal to $280,000 as computed below:

Assets – Liabilities = Owner’s Equity

$400,000 – $120,000 = $280,000

Example 1:
Using the concept of accounting equation, compute missing figures from the following:

1. Assets = $100,000, Liabilities = $40,000, Owner’s equity = ?

2. Assets = ?, Liabilities = $20,000, Owner’s equity = $30,000
3. Assets = $120,000, Liabilities = ?, Owner’s equity = $80,000
4. Assets = ?, Liabilities + Owner’s equity = $300,000

Solution

1. Owner’s equity = Assets – Liabilities

= $100,000 – $40,000
= $60,000
2. Assets = Liabilities + Owner’s equity
= $20,000 + $30,000
 = $50,000
3. Liabilities = Assets – Owner’s equity
= $120,000 – $80,000
= $40,000
4. The basic accounting equation is: Assets = Liabilities + Owner’s equity. Therefore, If liabilities
plus owner’s equity is equal to $300,000, then the total assets must also be equal to
$300,000.

Impact of transactions on accounting equation

Valid financial transactions always result in a balanced accounting equation which is the
fundamental characteristic of double entry accounting (i.e., every debit has a corresponding credit).

Every transaction impacts accounting equation in terms of dollar amounts but the equation as a
whole always remains in balance. Any increase in one side is balanced either by a corresponding
decrease in the same side or by a corresponding increase in the other side and any decrease is
balanced either by a corresponding increase in the same side or by a corresponding decrease in
the other side. For better explanation, consider the impact of twelve transactions included in the
following example:

Example 2:
Mr. John started a T-shirts business to be known as “John T-shirts”. He performed following
transactions during the first month of operations:

1. Mr. John invested a capital of $15,000 into his business.

2. Acquired a building for $5,000 cash for business use.
3. Bought furniture for $1,500 cash for business use.
4. Purchased T-shirts from a manufacturer for $3,000 cash.
5. Sold T- shirts for $1,000 cash, the cost of those T-shirts were $700.
6. Purchased T-shirts for $2,000 on credit.
7. Sold T-shirts for $800 on credit, the cost of those shirts were $550.
8. Paid $1,000 cash to his payables.
9. Collected $800 cash from his receivables.
10. The shirts costing $100 were stolen by someone.
11. Mr. John paid $150 cash for telephone bill.
12. Borrowed money amounting to $5,000 from City Bank for business purpose.

Required: Explain how each of the above transactions impacts the accounting equation of John T-
shirts.

Solution

Transaction 1: The investment of capital by John is the first transaction of John T-shirts which
creates very initial accounting equation of the business. At this point, the cash is the only asset of
business and owner has the sole claim to this asset. Therefore, the equation would look like the
following:

Equation element(s) impacted as a result of transaction 1: “Assets” & “Owner’s equity”.

Transaction 2: The second transaction is the purchase of building which brings two changes.
First, it reduces cash by $5,000 and second, the building valuing $5,000 comes into the business.
In other words, cash amounting to $5,000 is converted into building. The impact of this transaction
on accounting equation is shown below:

Equation element(s) impacted as a result of transaction 2: “Assets”

Transaction 3: The impact of this transaction is similar to that of transaction number 2. Cash goes
out of and furniture comes in to the business. On asset side, The reduction of $1,500 in cash is
balanced by the addition of furniture with a value of $1,500.

Equation element(s) impacted as a result of transaction 3: “Assets”

Transaction 4: The impact of this transaction is similar to transactions 2 and 3. One asset (i.e,
cash) goes out and another asset (i.e, inventory) comes in. The cash would decrease by $3,000
and at the same time the inventory valuing $3,000 would be recorded on the asset side.

Equation element(s) impacted as a result of transaction 4: “Assets”

Transaction 5: In this transaction, shirts costing $700 are sold for $1,000 cash. It increases cash
by $1,000 and reduces inventory by $700. The difference of $300 is the profit of the business that
would be added to the capital. The whole impact of this transaction on accounting equation is
shown below:

Equation element(s) impacted as a result of transaction 5: “Assets” & “Owner’s equity”

Transaction 6: In this transaction, T-shirts costing $2,000 are purchased on credit. It increases
inventory on asset side and creates a liability of $2,000 known as accounts payable (abbreviated
as A/C P.A) on the equity side of the equation. Since it is a credit transaction, it has no impact on
cash.

Equation element(s) impacted as a result of transaction 6: “Assets” & “liabilities”

Transaction 7: In this transaction, the business sells T-shirts costing $550 for $800 on credit. It
reduces inventory by $550 and creates a new asset known as accounts receivable (abbreviated as
A/C R.A) valuing $800. The difference of $250 is profit of the business and would be added to
capital under the head owner’s equity.
Equation element(s) impacted as a result of transaction 7: “Assets” & “Owner’s equity”

Transaction 8: In this transaction, business pays cash amounting to $1,000 for a previous credit
purchase. It will reduce cash and accounts payable liability both with $1,000.

Equation element(s) impacted as a result of transaction 8: “Assets” & “Liabilities”

Transaction 9: In this transaction, the business collects cash amounting to $800 for a previous
credit sale. On asset side, it increases cash by $800 and reduces accounts receivable by the same
amount.

Equation element(s) impacted as a result of transaction 9: “Assets”

Transaction 10: The loss of shirts by theft reduces inventory on asset side and capital on equity
side both by $100. All expenses and losses reduce owner’s equity or capital.

Equation element(s) impacted as a result of transaction 10: “Assets” & “Owner’s equity”

Transaction 11: The payment of telephone and electricity bills are business expenses that reduce
cash on asset side and capital on equity side both by $150.

Equation element(s) impacted as a result of transaction 11: “Assets” & “Owner’s equity”
Transaction 12: The loan is a liability because the John T-shirts will have to repay it to the City
Bank. This transaction increases cash by $5,000 on asset side and creates a “bank loan” liability of
$5,000 on equity side.

Equation element(s) impacted as a result of transaction 12: “Assets” & “Liabilities”

In above example, we have observed the impact of twelve different transactions on accounting
equation. Notice that each transaction changes the dollar value of at least one of the basic
elements of equation (i.e., assets, liabilities and owner’s equity) but the equation as a whole does
not lose its balance.

MORE FROM INTRODUCTION TO FINANCIAL ACCOUNTING (EXPLANATIONS):

Branches of accounting

Users of accounting information

Accounting equation

Expanded accounting equation

Double entry system of accounting

Account and its format

Chart of accounts

Classification of accounts

Business transaction

Rules of debit and credit

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Accounting equation

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Assume that assets and liabilities increased by Br.240,000, and Br. 120,000 respectively during a
given year. Assume the following additional particulars further
Revenues generated during the year….Br.80,000
Additional investment made by the owner during the year ……….Br. 70,000
Amount is withdrawn by the owner during the year….. $10,000
Required: Determine the amount of expense incurred during the year

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