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Understanding the Accounting Equation [Notes

with PDF]

by admin

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In this article, we will learn in-depth about the accounting equation, including
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its definition, basic and expanded accounting equations, examples, uses, and
much more.

Table of Contents

What is the Accounting Equation?

Important Note about Accounting Equation
Basic Accounting Equation
Expanded Accounting Equation
Examples and Uses of Accounting Equation

What is the Accounting Equation?

In a given time, the total assets should be equal to the sum of the liabilities
and the equity of the owner. The equation that represents this basic
framework is called the Accounting Equation.

Here we will learn

1. Basic Accounting Equation

2. Expanded Accounting Equation
3. Accounting Equation Example

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Important Note about Accounting Equation
 1. It is applicable to all business transactions.
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2. It applies to both small businesses and large corporations.
3. Provides the underlying framework for recording and summarizing
business transactions.

Basic Accounting Equation

Formula of the Basic Accounting Equation is given below  

A=L+OE  

Here,

A     = Assets

L     = Liabilities

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OE  = Owner’s Equity  
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So we can Say,   Assets   =   Liabilities    +    Owner’s Equity

“The relationship of the basic accounting equation is that the

assets must be equal to the sum of the liabilities and the
equity of the owner.” 

Expanded Accounting Equation

 Assets   =   Liabilities + Owner’s Capital-Owner’s Drawings + Revenues –
Expenses

Let’s explain the Assets, Liabilities, and Owner’s Equity to better understand
the Accounting Equation.

Assets: 

Assets are the resources the company owns. The company uses its assets to
carry out activities such as production and sales.   

The common feature of all assets is the ability to provide future services or 
benefits. In a business, that service potential or future economic benefit will
ultimately result in cash inflows (receipts).
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Example of Assets:

Cash and Cash Equivalents

Accounts Receivable
Inventory
Prepaid Expenses
Plant and Machinery
Furniture
Investment
Land

Liabilities: 

Liabilities are business legal financial debt and obligation against assets. it
arises during the business Operation.  

Example of Liabilities:

Accounts Payable
Notes Payable
Accrued Expenses Payable
Income tax payable
Loans
Borrowings
Bank Draft
Differed Revenues

Owner’s Equity:  

The owner’s claim on total assets is called the owner’s equity.  

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1. Owner’s Equity = total assets – total Liabilities.

2. Owner’s Equity= Owner’s Investment- Owner’s Drawings + Net Profit-
Net Loss
3. Owner’s Equity is increased by the Owner’s investment and Business
Revenues
4. Owner’s Equity is decreased by the Owner’s Drawings and Business
Expenses.

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Examples and Uses of Accounting Equation

Let’s try to understand the practical uses of the accounting equation by taking
some examples that will make it clear if there is any blur in your mind.

Let’s start with  Examples of Accounting Equation  

Example-1: Mr X invested cash $18,000 in the business.  

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Here involved 2 accounts

Accounts Accounts Type Increase/Decrease

Cash  Asset Increase

Capital Owner’s Equity   Increase  

Impact

Asset    = Liabilities + Owners’ Equity

Cash(+$18,000)                    = 0 + Capital (+ $18,000)

Example-2: Purchase an office table for cash $1,000  

Here involved 2 accounts  

Accounts Accounts Type Increase/Decrease

Furniture (Table)                Asset Increase

Cash   Asset Decrease  

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Impact
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Owners’
Asset    = Liabilities +
Equity

Cash (- $1,000) Furniture

= 0 + 0 
(+$1,000)                     

Example-3: Purchase Goods from “Y” Company for $3000 on credit.  

Here involved 2 accounts  

Accounts Accounts Type Increase/Decrease

Inventory (Goods)                Asset Increase

A/c Payable (Y Company)   Liabilities Increase  

Impact

Owners’
Asset    = Liabilities +
Equity

Inventory(+$3,000)                     A/c Payable(+$3,000)

= + 0 
               

 Example-4: Salaries paid for cash $2000  

Here involved 2 accounts  

Accounts Accounts Type Increase/Decrease

Salaries Expenses                  Owner’s Equity            Decrease 

 Cash Asset Decrease  
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Impact

Asset    = Liabilities + Owners’ Equity

Cash (-$2,000)     
= 0             + Salaries Exp. (-$2,000)
                           

Example-5: Services provided for $4,000 Cash and $5,000 on Credit  

Here involved 3 accounts  

Accounts Accounts Type Increase/Decrease

Accounts Receivable               Asset Increase  

Cash Asset Increase  

Service revenue                      Owner’s Equity Increase  

Impact

Asset    = Liabilities + Owners’ Equity

Service
A/c Receivable(+$5,000) Cash
= 0             + Revenue(+$9,000)
(+$4,000)                
 

Example-6: Cash $ 1,500 received from Customer.  

Here involved 2 accounts  

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 Accounts Accounts Type Increase/Decrease
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Accounts Receivable               Asset Decrease  

Cash Asset Increase  

Impact

Owners’
Asset    = Liabilities +
Equity

A/c Receivable(-$1,500) Cash (+$1,500)  

= 0             + 0 
             

Example-7: Wages outstanding for the month of September 2019 $400  

Here involved 2 accounts  

Accounts Accounts Type Increase/Decrease

Wages Expenses                       Owner’s Equity Decrease  

Wages Payable                         Liabilities Increase  

Impact

Asset    = Liabilities + Owners’ Equity

0                 = Wages Payable (+$400)         + Wages Esp. (-$400)

 If we analyze the above examples of accounting equations, we find that the
total assets at any time will be equivalent to the funds mobilized by the
company, i.e. Creditors ‘ claims and owners ‘ fairness. 
This connection is referred to as the accounting equation or balance sheet, i.e.
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Assets= liabilities + capital.

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