Business, Legal & Accounting Glossary
The relationship between assets, liabilities and ownership interest.
Also known as the balance-sheet equation, The accounting equation is the underlying formula of a balance sheet.
It is expressed as: assets = liabilities + capital.
An increase (or decrease) in the total assets of a concern needs to be accompanied by an equal movement in the liabilities and capital in order to ensure that they always balance.
Hence, the balance in balance sheet.
This formula expresses an entity view of a business, whereas an proprietary view deducts liabilities from assets to calculate an owners’ stake in a business.
The basic accounting equation is the foundation for the double-entry bookkeeping system. It shows how assets were financed: either by borrowing money from someone else (liability) or by paying your own money (shareholder’s equity).
Assets = Liabilities + (Shareholders or Owners equity)
For example, say a student buys a computer for $945. This student borrowed $500 from his best friend and saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.
The formula can be re-written:
Assets − Liabilities = (Shareholders or Owners equity)
Now it shows that owner’s interest is equal to property (assets) minus debts (liabilities). Since in a company, owners are shareholders, the owner’s interest is called shareholder’s equity. Every accounting transaction affects at least one element of the equation, but always balances.
Simplest transactions also include:
| Transaction Number |
Assets | Liabilities | Shareholder’s Equity |
Explanation | |||
|---|---|---|---|---|---|---|---|
| 1 | + | 6,000 | + | 6,000 | Issuing stocks for cash or other assets | ||
| 2 | + | 10,000 | + | 10,000 | Buying assets by borrowing money (taking a loan from a bank or simply buying on credit) | ||
| 3 | – | 900 | – | 900 | Selling assets for cash (in essence, it’s just an exchange of one asset to another) | ||
| 4 | + | 1,000 | + | 450 | + | 550 | Buying assets by paying cash (550) and by borrowing money (450) |
| 5 | + | 700 | + | 700 | Earning revenues | ||
| 6 | – | 200 | – | 200 | Paying expenses (e.g. rent or professional fees) or dividends | ||
| 7 | + | 100 | – | 100 | Recording expenses, but not paying them at the moment | ||
| 8 | – | 500 | – | 500 | Paying a debt that you owe | ||
| 9 | – | 200 | – | 200 | Receiving cash for the sale of an asset | ||
These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.
An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity and makes sure it balances (thus its name).
Luca Pacioli is notable for including the first published description of the method of keeping accounts that Venetian merchants used during the Italian Renaissance, known as the double-entry accounting system.
Also, David Flath asserts that Japanese merchants have used double-entry accounting for centuries:
assets= liabilities+capital+ additional investments + revenue or income – withdrawals -expenses or losses
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This glossary post was last updated: 11th August, 2022 | 0 Views.