At the core of accounting is the accounting equation, which expresses the relationship between what is owned by an entity (assets), and how these assets are financed (liabilities and equity).
Assets (A) = Liabilities (L) plus Equity (E)
A = L + E
In an equation, the left hand side of the equals sign must always equal the right hand side of the equals sign. In other words it must 'balance'. For example;
\$1,000 = \$300 + \$700
In accounting, this is where the term 'balance sheet' comes from. The total value of all assets must be equal to the total of the liabilities and equity of the firm. If one side increases, then the other side must also increase, and vice versa.
For example, imagine a business has liabilities of \$30,000 and equity of \$10,000. We can use this information to determine the total assets of the business.
A = L + E A = \$30,000 + \$10,000
\$40,000 = \$30,000 + \$10,000
As we know that the left hand side of the equation must always equal the right hand side, we can also calculate the liabilities or equity.
For example, imagine a business has assets of \$20,000 and liabilities of \$15,000. To calculate the equity;
A = L + E \$20,000 = \$15,000 + E
\$20,000 = \$15,000 + \$5,000
We found the value of the equity by subtracting the liabilities from the assets. You can learn more about rearranging equations in the next page.
It is very important to understand the accounting equation, as it allows us to ensure every business transaction has been accounted for correctly using the balance sheet.
The accounting equation is the fundamental formula in accounting—it shows that assets are equal to liabilities plus owner’s equity. It’s the reason why modern-day accounting uses double-entry bookkeeping as transactions usually affect both sides of the equation. The accounting equation is an accounting fundamental that bookkeepers need to master to be proficient.
We express the accounting equation as:
Assets = Liabilities + Owner’s equity
Components of the Accounting Equation
There are three major components in the accounting equation: assets, liabilities, and owner’s equity. These also represent the major account groups in the chart of accounts.
Assets
Assets in accounting are resources that a company owns and uses to generate income and future economic benefits. They can be classified as operating or nonoperating, tangible or intangible, and current or noncurrent.
Liabilities
Liabilities are amounts owed to other persons or entities as a result of a past event and involve a future settlement using cash, goods, or services. Customers and vendors can be sources of liabilities for operations. Paying taxes, fees, permits, and salaries are liabilities once they become due but aren’t yet paid. Businesses use their assets to pay liabilities.
Owner’s Equity
Owner’s equity is the residual interest or amount that assets exceed liabilities. It also represents the amount of paid-in capital and retained earnings as a result of doing business for profit.
Calculating Owner’s Equity
Deducting total liabilities from total assets is the way to calculate owner’s equity when a business is formed initially. After that, owner’s equity should be rolled forward from the prior period using this equation:
Ending owner’s equity = Beginning owner’s equity + Investments – Distributions + Net income
After calculating the owner’s equity with the formula above, you should plug it into the accounting equation and make sure the equation balances. In other words, the ending owners’ equity from this equation should equal assets minus liabilities at the end of the year. If it doesn’t, then your books are out of balance, most likely because there was an entry made to an owner’s equity account that isn’t reflected in your calculation above.
Debits & Credits in the Accounting Equation
Double-entry bookkeeping is based on debits and credits. A common misunderstanding of most people is that debits always pertain to increases, while credits always pertain to decreases.
But, in simple terms, debits and credits are merely the two sides of the accounting equation. Debits increase the left side of the equation (assets) or decrease the right side of the equation (liabilities and owner’s equity).
A useful tool for analyzing how transactions change an accounting equation is the T-account. 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.
The accounting equation and the effects of debits and credits
Revenues & Expenses in the Accounting Equation
Revenues and expenses are subcomponents of owner’s equity. However, these two aren’t directly added and deducted to owner’s equity. Only the net income (revenues > expenses) or net loss (expenses > revenues) is reflected in owner’s equity. The image below shows the relationship of revenues, expenses, net income, and owner’s equity.
The accounting equation and effects on revenues and expenses
Effects of Transactions on the Accounting Equation
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.
Legend:
Let’s illustrate each transaction using sample transactions.
Al’s Toy Barn sells and repairs toys. During 2020, the company earned $1,200 fees from repairing action figures. The journal entry to record a sale on credit is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| + 1,200 | No Effect | + 1,200 |
Deferred revenues arise when customers make an advanced payment for goods or services that are yet to be performed. Instead of recognizing it as revenue, we record it first as a liability until we deliver the goods to our customers. To illustrate, assume that a customer made an advance payment of $500 as a reservation for the upcoming PS5 Pro. The journal entry to record deferred revenue is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| + 500 | + 500 | No effect |
When you purchase assets using cash, there’s an offsetting effect only in the asset section—it will not affect liabilities and equity. To illustrate, let’s assume that the owner of Al’s Toy Barn purchased new action figures worth $5,000 using cash. The journal entry to record the purchase is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| + 5,000 | ||||
| – 5,000 | = | |||
| No effect | No effect | No effect |
Purchasing assets on credit affects both assets and liabilities. Let’s assume that Al’s Toy Barn purchased dolls worth $3,500 on credit. The journal entry to record the credit purchase is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| + 3,500 | + 3,500 | No effect |
Let’s assume that Al’s Toy Barn paid $1,000 in utility bills. The journal entry to record the payment is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| – 1,000 | No Effect | – 1,000 |
Expenses decrease equity because it decreases net income. Remember that at the end of the period, we close net income to equity.
Accrued expenses occur when you record an expense even if it is not yet paid. It’s important to accrue expenses so that you record them in the proper accounting period even if you delay payment until the next accounting period. Common examples of accrued expenses would be payroll accruals or accrued rent expenses.
To illustrate, let’s assume that the December rent of $1,500 is due on January 5th of the next year. Even if the payment will be made next year, we can accrue it in December so that it will be shown as an expense of December. The journal entry to record the accrual is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| No Effect | + 1,500 | – 1,500 |
Based on the data in the previous section, here’s the journal entry to record the payment of the accrued December rent in January.
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| – 1,500 | – 1,500 | No Effect |
The journal entry to record depreciation includes an expense account and a contra asset account. Accumulated depreciation is a contra asset account that is included in the assets portion of the accounting equation and reduces the book value of fixed assets. Let’s assume that the depreciation of Al’s Toy Barn’s fixed assets is $1,200. The journal entry to record depreciation is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| – 1,200 | No Effect | – 1,200 |
Transfers between bank accounts have no effect in total assets since it only transfers cash from one asset account to another. Let’s assume that Al’s Toy Barn transferred $15,000 from its checking account to its payroll account. The journal entry to record the transfer is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| + 15,000 | ||||
| – 15,000 | = | |||
| No effect | No effect | No effect |
Cash investments increase the assets and equity of the business. Let’s assume that Sam Smith, the owner of Al’s Toy Barn, invested $50,000 cash to fund its plans to build a second branch. The journal entry to record the investment is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| + 50,000 | No Effect | + 50,000 |
Paying credits decreases both liabilities and assets. To illustrate, let’s assume that Al’s Toy Barn paid $3,500 to its doll supplier. The journal entry to record the payment is:
The effect on the accounting equation is:
| Assets | = | Liabilities | + | Equity |
| – 3,500 | – 3,500 | No effect |
Frequently Asked Questions (FAQs)
What’s the difference between a T-account and ledger?
A T-account is a visual representation of the general ledger, whereas the general ledger is an accounting record that shows more detailed information than a T-account. Accountants and bookkeepers use the T-account to analyze transactions and spot errors easily without going through detailed ledger information.
What is double-entry bookkeeping?
Double-entry bookkeeping is a fundamental accounting concept that requires every financial transaction to affect at least two different accounts. It also requires that all entries must have equal debits and credits.
Bottom Line
The accounting equation is the most fundamental concept in accounting. It’s the compass that guides all accountants and bookkeepers, even if transactions get complex. For small businesses, knowing how the accounting equation works can help you better understand financial statements, along with how bookkeepers do their jobs.