What is Basic Accounting Equation?
The accounting equation is a fundamental formula that states a company's total assets are always equal to the sum of its liabilities and shareholders' equity. This is also called Basic accounting equation.
Assets = Liabilities + Equity
The accounting equation, also known as the balance sheet equation or the
fundamental accounting equation, is a key concept in accounting. The accounting
equation is derived from the double-entry bookkeeping system, where every
business transaction is recorded with equal debits and credits. This ensures
balance when preparing financial statements. From the accounting equation we
can state the formula to calculate Liability and Equity
Liabilities= Assets - Capital
Owners’ Equity
(Capital) = Assets – Liabilities
Expanded Accounting Equation
The expanded Accounting Equation is express as
Assets = Liabilities + Owner’s Capital + Revenues – Expenses – Owner’s Drawings
This version of the accounting equation provides a more detailed view of a company’s financial position by incorporating the effect of revenues, expenses, and owner’s withdrawals on the owner's equity. It highlights how business operations and owner activity affect the overall financial structure of the company.
The accounting equation includes two essential formulas that are key to
accrual accounting and the double-entry system. These two fundamental
principles set accrual accounting apart from cash-based accounting and
distinguish the double-entry system from the single-entry system:
1. The first is the basic accounting equation: Assets = Liabilities +
Equity.
2. The second is the "Expanded Accounting Equation," which
integrates the basic equation with the secondary equation: Debits = Credits.
These concepts are specific to the accrual accounting system and do not
apply to cash-based, single-entry accounting systems.
Debits = Credits
The accounting equation builds upon the 'Basic Equation' by adding
another essential rule that applies to all accounting transactions within a
double-entry bookkeeping system:
Debits = Credits
This accounting equation emphasizes the following key concepts:
- Debits
and credits must always be equal for every transaction impacting accounts.
- Throughout
any specified period, the total of all debit entries must equal the total of
all credit entries, maintaining consistent balance for each pair of entries
associated with a transaction.
This equation acts as a crucial built-in error-checking mechanism for
accountants during the preparation of financial statements.
Accounting Equation Examples
Let’s illustrate the accounting equation with an example.
John, a sole proprietor, records the following transactions in his books
for the year 2023:
· Jan 1: Invested capital of $ 20,000.
·
Jan 2:
Purchased goods on credit from Tommy & Co. for $ 2,000.
·
Jan 4:
Bought plant and machinery for $ 8,000 in cash.
·
Jan 8:
Purchased goods for $ 4,000 in cash.
·
Jan 12:
Sold goods for $ 6,000 (cost of inventory 4,000 + profit 2,000) in cash.
·
Jan 18:
Paid Tommy & Co. $ 1,000 in cash.
·
Jan 22:
Received $ 300 from Mr. Micle (a debtor).
·
Jan 25:
Paid salary of $ 6,000.
·
Jan 30:
Received interest of $ 5,000.
·
Jan 31:
Paid wages of $ 3,000.
The impact of these transactions on assets, liabilities, and owner’s
equity, according to the accounting equation, is as follows:
|
Date |
Transactions |
Assets
= |
Liabilities
+ |
Owner’s
Equity (Capital) |
|
01.01.23 |
Capital
investment 20,000 |
20,000 |
- |
20,000 |
|
02.01.19 |
Purchased
goods on credit |
+ 2000 |
+ 2,000 |
- |
|
|
Revised
equation |
22,000 = |
2000 + |
20,000 |
|
04.01.19 |
Bought
plant and machinery cash 8,000 |
+8,000 |
- - |
- - |
|
|
Revised
equation |
22,000 = |
2000 + |
20,000 |
|
08.01.19 |
Purchased
goods for cash 4000 |
+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 |
- - |
+2,000 |
|
|
Revised
equation |
24,000 = |
2000 + |
22,000 |
|
18.01.19 |
Paid
to Tommy & Co.,
in cash 1,000 |
-1,000 |
-1,000 |
- |
|
|
Revised
equation |
23,000 = |
1000 + |
22,000 |
|
22.01.19 |
Received
from Mr. Micle 300 (being a debtor) |
-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 |