Definition, Explanation and Examples

For small businesses, knowing how the accounting equation works can help you better understand financial statements, along with how bookkeepers do their jobs. Since the accounting equation depicts a mathematical equality, it also goes that all debits must always equal all credits. In other words, a journal entry should have a minimum of at least one debit entry and one credit entry, and the total of those entries must be equal. A useful tool for analyzing how transactions change an accounting equation is the T-account.

The accounting equation is also called the basic accounting equation or the balance sheet equation. But, that does not mean you have to be an accountant to understand the basics. Part of the basics is looking at how you pay for your assets—financed with debt or paid for with capital. To further illustrate the analysis of transactions and their effects on the basic accounting equation, we will analyze the activities of Metro Courier, Inc., a fictitious corporation. Refer to the chart of accounts illustrated in the previous section. An error in transaction analysis could result in incorrect financial statements.

What Is an Asset in the Accounting Equation?

The left side of a T-account is for debits, whereas the right side is credits. However, the effect of debits and credits on the balance in a T-account depends upon which side of the accounting equation an account is located. Each example shows how different transactions affect the accounting equations. If your business has more than one owner, you split your equity among all the owners.

Accounting equation describes that the total value of assets of a business entity is always equal to its liabilities plus owner’s equity. This equation is the foundation of modern double entry system of accounting being used by small proprietors to large multinational corporations. Other names used for this equation are balance sheet equation and fundamental or basic accounting equation. Income and expenses relate to the entity’s financial performance. Individual transactions which result in income and expenses being recorded will ultimately result in a profit or loss for the period. The term capital includes the capital introduced by the business owner plus or minus any profits or losses made by the business.

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

The accounting equation is also called the balance sheet equation. Thus, you have resources with offsetting claims against those resources, either from creditors or investors. All three components of the accounting equation appear in the balance sheet, which reveals the financial position of a business at any given point in time. The equation is generally written with liabilities appearing before owner’s equity because creditors usually have to be repaid before investors in a bankruptcy. In this sense, the liabilities are considered more current than the equity. This is consistent with financial reporting where current assets and liabilities are always reported before long-term assets and liabilities.

Under all circumstances, each transaction must have a dual effect on the accounting transaction. For instance, if an asset increases, there must be a corresponding decrease in another asset or an increase in a specific liability or stockholders’ equity item. The shareholders’ equity number is a company’s total assets minus its total liabilities. An organisation ABC wish to buy a ₹500 manufacturing machine using cash. This deal will result in debt of (-₹500) for equipment and (+₹500) as a credit to cash. Owner’s equity is the residual interest or amount that assets exceed liabilities.

What Are The Limitations of The Accounting Equation?

When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as the double-entry accounting or bookkeeping system. The asset, liability, and shareholders’ equity portions of the accounting equation are explained further below, noting the different accounts that may be included in each one. The purpose of this article is to consider the fundamentals of the accounting equation and to demonstrate how it works when applied to various transactions. Companies compute the accounting equation from their balance sheet. They prove that the financial statements balance and the double-entry accounting system works.

In above example, we have observed the impact of twelve different transactions on accounting equation. Notice that each transaction changes the dollar value of at least one of the basic elements of equation (i.e., assets, liabilities and owner’s equity) but the equation as a whole does not lose its balance. The accounting equation uses total assets, total liabilities, and total equity in the calculation.

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