Accounting Equation – Definition, Formula and Examples

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Tally Solutions | Dec-02-2019

Accounting Equation – Definition

The accounting equation summarizes the essential nature of double-entry system of accounting. Under which, the debit always equal to credit, and assets always equal to the sum of equities and liabilities. Accounting equation can be simply defined as a relationship between assets, liabilities and owner’s equity in the business.

Accounting Equations Rules

The accounting equation connotes two equations that are basic and core to accrual accounting and double-entry accounting system.

The following are two basic rules of accounting equation that distinguishes the accrual system of accounting from cash basis accounting, and single-entry system from the double-entry system:

  • The first among them is the basic accounting equation which written as Assets = Liabilities + Equities.
  • The second one is termed as ‘Expanded Accounting Equation’ which is a combination of the basic equation and secondary equation i.e. Debit = Credit.

It derives its status only from the accrual system of accounting and thereby, it does not apply in a cash-based, single-entry accounting system.

Accounting Equation Fundamentals

The balance sheet always balances - Asset = Liability + Owner’s equities

It is pertinent to note that the term basic accounting equation is another name for the ‘Balance Sheet Equation’. The reason balance sheet always balances is because of the following equation:

Assets = Liabilities + Owners Equities

The ingredients of this equation - Assets, Liabilities, and Owner's equities are the three major sections of the Balance sheet. By using the above equation, the bookkeepers and accountants ensure that the "balance" always holds i.e., both sides of the equation are always equal.

Total debits always equal to total credits -Total Debits = Total Credits

The accounting equation represents an extension of the ‘Basic Equation’ to include another fundamental rule that applies to every accounting transaction when a double-entry system of bookkeeping is used by the businesses.

Debits = Credits

This Accounting Equation summarizes the following:

  • Debit and Credit should be equal for every event that impacts accounts.

  • Across any specified timespan, the sum of all debit entries must equal the total of all credit entries, meaning the same balance applies for every pair of ‘entries’ that follows a transaction.

This equation serves to provide an essential form of built-in error checking mechanism for accountants while preparing the financial statements.

Types of Accounting Equation and Formulae correlation

The entire financial accounting depends on the accounting equation which is also known as the ‘Balance Sheet Equation’. The following are the different types of basic accounting equation:

  • Asset = Liability + Capital
  • Liabilities= Assets - Capital
  • Owners’ Equity (Capital) = Assets – Liabilities

Assets = Liabilities + Owner’s equity

This balance sheet equation tells you that all the assets owned by the business are either sponsored using the owners’ equity or the amount which company should owe others like suppliers or borrowings like Loans

Liabilities = Assets – Owner’s Equity

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.

Owners’ Equity = 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.

Accounting Equation Examples

Let us understand the accounting equation with the help of an example.

Mr Ram, a sole proprietor has the following transactions in his books of accounts for the year 2019.

  • Jan 1 Invested Capital of 20,000 Indonesian Rupiah.
  • Jan 2 Purchased goods on credit from Das & Co. for 2,000 Indonesian Rupiah.
  • Jan 4 Bought plat and machinery for 8,000 Indonesian Rupiah on cash.
  • Jan 8 Purchased goods for 4,000 Indonesian Rupiah on cash.
  • Jan 12 Sold goods for (cost of inventory 4,000 + profit 2,000) 6,000 Indonesian Rupiah on cash
  • Jan 18 Paid to Das & Co. in cash 1,000 Indonesian Rupiah
  • Jan 22 Received 300 Indonesian Rupiah from Mr Y (being a debtor)
  • Jan 25 Paid salary of 6,000 Indonesian Rupiah
  • Jan 30 Received interest of 5,000 Indonesian Rupiah
  • Jan 31 Paid wages of 3,000 Indonesian Rupiah
  • The effect of above transactions on Assets, liabilities and owner’s equity considering the accounting equation is as follows:

Amount ( in Indonesian Rupiah)

Date

Transactions

Assets =

Liabilities +

Owner’s Equity (Capital)

01.01.19

Capital brought into the business 20,000

20,000

-

20,000

02.01.19

Purchased goods on credit from Dad & Co., 2,000

+ 2000

+ 2,000

-

 

Revised equation

22,000 =

2000 +

20,000

04.01.19

Bought plant and machinery for cash 8,000

+8,000
-8,000

- -

- -

 

Revised equation

22,000 =

2000 +

20,000

08.01.19

Purchased goods for cash 4000

+4,000
-4,000

- -

- -

 

Revised equation

22,000 =

2000 +

20,000

12.01.19

Sold goods for cash (cost of inventory 4,000 + Profit 2,000) 6000

+6,000
-4,000

- -

+2,000

 

Revised equation

24,000 =

2000 +

22,000

18.01.19

Paid to Das and Co., in cash 1,000

-1,000

-1,000

-

 

Revised equation

23,000 =

1000 +

22,000

22.01.19

Received from Mr Y 300 (being a debtor)

-300
+300

- -

- -

 

Revised equation

23,000 =

1000 +

22,000

25.01.19

Paid salary 6,000

-6,000

-

-6,000

 

Revised equation

17,000 =

1000 +

16,000

30.01.19

Received interest 5,000

+5,000

-

+ 5,000

 

Revised equation

22,000 =

1000 +

21,000

31.01.19

Paid wages 3,000

-3,000

-

-3,000

 

Revised equation

19,000 =

1000 +

18,000

 

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