Resources | Subject Notes | Accounting
The accounting equation is a fundamental principle in accounting that forms the basis of the double-entry bookkeeping system. It states that a business's financial position is always maintained in balance.
The accounting equation can be represented as:
Assets = Liabilities + Equity
Let's break down each component:
Assets are resources owned by the business that have future economic value. They are what the business owns.
Examples of assets include:
Liabilities are obligations owed by the business to external parties (creditors). They represent what the business owes to others.
Examples of liabilities include:
Equity represents the owners' stake in the business. It's the residual interest in the assets after deducting liabilities.
For a sole trader or partnership, equity is often referred to as capital. For a company, it's called share capital and retained earnings.
Examples of equity include:
The accounting equation must always remain in balance. Any transaction will affect at least two elements of the equation, ensuring the equation stays in equilibrium.
Here's a table illustrating how different transactions affect the accounting equation:
| Transaction | Assets | Liabilities | Equity |
|---|---|---|---|
| Buying Equipment for Cash | $\text{Increase}$ | $\text{No Change}$ | $\text{No Change}$ |
| Paying Suppliers by Cheque | $\text{Decrease}$ | $\text{No Change}$ | $\text{No Change}$ |
| Receiving Payment from a Customer | $\text{Increase}$ | $\text{No Change}$ | $\text{Increase}$ |
| Taking out a Loan from the Bank | $\text{Increase}$ | $\text{Increase}$ | $\text{No Change}$ |
| Owner Invests Cash into the Business | $\text{Increase}$ | $\text{No Change}$ | $\text{Increase}$ |
| Paying Salary to an Employee | $\text{Decrease}$ | $\text{No Change}$ | $\text{Decrease}$ |
Example:
A business has $10,000 in cash, $5,000 in inventory, and $2,000 in equipment. It also owes $3,000 to suppliers and has $4,000 in capital.
Assets: $10,000 (Cash) + $5,000 (Inventory) + $2,000 (Equipment) = $17,000
Liabilities: $3,000 (Suppliers)
Equity: $4,000 (Capital)
Check: $17,000 (Assets) = $3,000 (Liabilities) + $4,000 (Equity)
The equation balances.
The accounting equation is a cornerstone of accounting. Understanding it is crucial for analyzing a business's financial health and making informed decisions.