The accounting equation is the
unifying concept in accounting that shows the relationships between and among
the accounting elements: assets, liabilities, and capital.
In this lesson (and the next
ones), you will learn about the basic accounting equation and how it stays in
balance.
Before taking this lesson, be
sure to be familiar with the accounting
elements.
Basic Accounting Equation
The basic accounting equation is:
Assets = Liabilities + Capital
When a business is put up, its
resources (assets) come from two sources: contributions by owners (capital) and
those acquired from creditors or lenders (liabilities). In other words, all
assets initially come from liabilities and owners' contributions.
As business transactions take
place, the values of the accounting elements change. The accounting equation
nonetheless always stays in balance.
Every transaction has a two-fold
effect. Meaning, at least two accounts are affected. Let's illustrate all of
that through these examples.
Assume the following transactions:
Mr. Alex invested $20,000 to
start a printing business,
The company obtained a loan from
a bank, $30,000,
The company purchased printers
and paid a total of $1,000.
How will the transactions affect
the accounting equation?
Let us take a look at transaction
#1:
|
Transaction
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
|
1. Owner's investment
|
20,000.00
|
=
|
-
|
+
|
20,000.00
|
Again, every transaction has a
two-fold effect. In the above transaction, Assets increased as a
result of the increase in Cash. At the same time, Capital increased
due to the owner's contribution. Remember that capital is increased by
contribution of owners and income, and is decreased by withdrawals
and expenses. No liability is affected hence, stays at zero.
Let's continue with transaction
#2:
|
Transaction
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
|
1. Owner's investment
|
20,000.00
|
=
|
-
|
+
|
20,000.00
|
|
2. Loan from bank
|
30,000.00
|
=
|
30,000.00
|
+
|
-
|
In transaction #2, the company
received cash. Thus, the value of total assets is increased. At the same time,
it incurred in an obligation to pay the bank. Therefore, liabilities are
increased. The liability in this case is recorded as Loans Payable.
Notice that the accounting
equation is still equal (balanced).
Let's add transaction #3:
|
Transaction
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
|
1. Owner's investment
|
20,000.00
|
=
|
-
|
+
|
20,000.00
|
|
2. Loan from bank
|
30,000.00
|
=
|
30,000.00
|
+
|
-
|
|
3. Purchased printers
|
1,000.00
(1,000.00) |
=
|
-
|
+
|
-
|
The company acquired printers,
hence, an increase in assets. However, the company used cash to pay for the
printers. Thus, it also results in a decrease in assets. Transaction #3 results
in an increase in one asset (Service Equipment) and a decrease in another asset
(Cash).
For those who are new to
accounting format: The parentheses "()" around the 1,000
amount above means "minus" or "less".
Liabilities and capital are not
affected. Still, the equation in the third transaction is equal.In this case, it
has zero effect on both sides.
At this point, the balance of
total assets is $50,000. The combined balance of liabilities and capital is
also at $50,000.
The accounting equation is (and
should always be) in balance.
To help you better understand how
the accounting equation works and stays in balance, here are more sample
transactions and their effects to the accounting equation.
In addition to transactions 1, 2
and 3 in the previous
lesson, assume the following data:
Rendered services and received
the full amount in cash, $500
Rendered services on account (receivable
from customer), $750
Purchased office supplies on
account (payable to supplier), $200
Had some equipment repaired for
$400, to be paid after 15 days
Mr. Alex, the owner, withdrew
$5,000 cash for personal use
Paid one-third of the loan
obtained in transaction #2
Received customer payment from
services in transaction #5
The transactions will result to
the following effects:
|
Transaction
|
Assets
|
=
|
Liabilities
|
+
|
Capital
|
|
1. Owner's investment
|
20,000.00
|
=
|
|
+
|
20,000.00
|
|
2. Loan from bank
|
30,000.00
|
=
|
30,000.00
|
+
|
|
|
3. Purchased printers
|
1,000.00
(1,000.00) |
=
|
|
+
|
|
|
4. Service revenue for cash
|
500.00
|
=
|
|
+
|
500.00
|
|
5. Service revenue on account
|
750.00
|
=
|
|
+
|
750.00
|
|
6. Supplies on account
|
200.00
|
=
|
200.00
|
+
|
|
|
7. Repair of equipment
|
|
=
|
400.00
|
+
|
(400.00)
|
|
8. Owner's withdrawal
|
(5,000.00)
|
=
|
|
+
|
(5,000.00)
|
|
9. Payment of loan
|
(10,000.00)
|
=
|
(10,000.00)
|
+
|
|
|
10. Collection of accounts
|
750.00
(750.00) |
=
|
|
+
|
|
|
Balance
|
36,450.00
|
=
|
20,600.00
|
+
|
15,850.00
|
Examples Explained
The company received cash for
services rendered. Cash increased thereby increasing assets. At the
same time, capital is increased as a result of the income(Service Revenue). As
we've mentioned in the Accounting Elements lesson, income increases
capital.
The company rendered services on
account. The services have been rendered, hence, already earned. Thus, the $750
worth of services rendered is considered income even if the amount has not yet
been collected. Since the amount is still to be collected, it is recorded as Accounts
Receivable, an asset account.
Office supplies worth $200 were
acquired. This increases the company's Office Supplies, part of the
company's assets. The purchase results in an obligation to pay the supplier;
thus a $200 increase in liability (Accounts Payable).
The company incurred in $400 Repairs
Expense. Expenses decrease capital. The amount has not yet been paid. Thus, it
results in an increase in total liabilities.
The owner withdrew $5,000 cash. Cash is
decreased thereby decreasing total assets. Withdrawals or drawings decrease
capital.
One-third of the $30,000 loan was
paid. Therefore, Cash is decreased by $10,000 as a result of the
payment. And, liabilities are decreased because part of the obligation has been
settled.
The $750 account in a previous
transaction has been collected. Therefore, theAccounts Receivable account
is decreased and Cash is increased.
Notice that every transaction
results in an equal effect to assets and liabilities plus capital. The
beginning balances are equal. The changes arising from the transactions are
equal. Therefore, the ending balances would still be equal.
The balance of the total assets
after considering all of the above transactions amounts to $36,450. It is equal
to the combined balance of total liabilities of $20,600 and capital of $15,850 (a
total of $36,450).
Assets = Liabilities + Capital is
a mathematical equation. Using algebra, the formula can be rewritten to get
other versions of the equation.
Liabilities = Assets - Capital
Capital = Assets - Liabilities
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