The accounting equation is the most important part of the accounting process. The dual accounting technique is used in the accounting equation which means total assets must be equal to all the liabilities and this is also called the balance sheet equation.

You will learn about the accounting equation in detail.

Outline

• What is the accounting equation?
• Parts of the accounting equation
• Importance of accounting equation
• Examples of the accounting equation
• Conclusion

What is the accounting equation

The accounting equation is an equation for determining the relationship between monetary transactions. It is based on all the assets which should be equal to all the liabilities. The mathematical model of the accounting equation is Assets= liabilities + shareholder equity (A= L+SE). It is a method of expressing a business economic situation in which the total investments are equal to the total liabilities and shareholder equity.

The equation can also be modified to calculate it in different ways. such as liabilities or equity. To calculate liabilities, it can be stated as Liabilities = Assets – Owners Equity, and Owners Equity = Assets – Liabilities to calculate Owners’ equity.

Here is the accounting equation formula

assets= liabilities+shareholder equity

Parts of the accounting equation

let’s chunk down the accounting equation into parts:

Assets:  Assets are the resources that are under the control of the business. This is the sum of the total assets of the company; they can be objective or subjective, but they all relate to the company. It covers elements like property, receivable accounts, and most typically, money.

Permanent resources are valued that are projected to generate income and use for more than a year. Items, machinery, property investment, and structures are all included in assets.

Liabilities: This is a concept for the whole amount of money a business must pay in the short or long term. Liabilities are a key part of a business’s strategic plan because they are used to fund day-to-day activities as well as to develop the organization. For example account payable, long-term debt, etc.

Shareholder equity: It is the investment by the business owner in their business. The equity is calculated when we subtract the liabilities from the assets. for example, share capital and retained earnings, etc.

Assets – liabilities= shareholder equity

Hence, we can say that the total assets should always be equal to the liabilities in the balance sheet equation.

Example #1

Mr. David started a new construction business and he invested the capital of $30,000. The $ 30,000 is the equity of David;  due to capital investment company’s cash assets also increase along with the increase in capital.

Total assets = liabilities + shareholder equity

$30,000 = $0+ $30,000

$30,000 = $30,000

As a result, we can say that Assets are equal to liabilities.

Example #2

Now he starts the construction and decides to borrow  $10,000 from the bank to purchase cement, blocks, and other equipment.

Total assets = liabilities+shareholder equity

$40,000 = $ 10,000 + 30,000

$40,000 = $40,000

Hence we can say that LHS=RHS.

 Example #3

Let’s suppose I want to build my own business. The cost of business is $25,000 and I owe $5,000 to the bank. My equity in the business is $20,000.

Assets = liabilities+shareholder equity  

$25,000 = $5,000+$20,000

$25,000 = $25,000

Assets – liabilities =  shareholder equity

$25,000-$5,000 = $20,000

$20,000 = $20,000

Hence we can say that the total assets are equal to the total liabilities.

Examples of the accounting equation 

Example # 1

• On December 01, 2010, john started his own business he invested his capital of $20,000.
• On December 30, 2010, he purchased pieces of furniture for his business and the cost of furniture was  $5,000.
• John paid the salary/wage on January 02, 2011, $10,000.
• 15, January, 2011, John obtained an agreement from the company xyz, and receive payment of $3,000.
• On February 02, 2011, he signed another agreement and receive $5,000 in advance .
• On February 10, 1011, John completed the agreement which was signed on February 02, 2011

Date	Account description	Debit	Credit
01,12,2010	Cash	$20,000
	Personal capital		$20,000
30,12,2010	furniture	$5,000
	Cash		$5,000
02,01,2011	Labor’s wage	$10,000
	Cash		$10,000
15,01,2011	Cash	$3,000
	Service revenue		$3,000
02,02 2011	Cash	$5,000
	unearned revenue		$ 5,000
10,02,2011	Unearned revenue	$5,000
	Revenue		$5,000
	total	$48,000	$ 48,000

Example # 2

Brad established a paper company on January 05, 2019. Brad’s personal capital/money investment of $25,000 in recovery for $10,000 shares of the paper company and the first marketing he will register for his company. There were no deals or liabilities on January 05, 2019, because the company did not obtain any delivery costs. What technique will be used to recover the transactions in the balance sheet?

As a result, we can say that cash from brand personal investment and stockholder equity is directly proportioned to each other this means assets are directly proportionated to the liabilities.

Importance of accounting equation

The accounting equation describes the relationship between the assets, liabilities, and shareholder equity of any organization. If all other factors remain constant, a business’s stock will rise as its capital rises, and simultaneously. It is fundamental because it can provide a clear picture of the income statement.

It is the backbone for double-entry bookkeeping and is the rule for accounting information. You can’t read your cash flow or analyze your income statements without understanding the balance sheet equation. The accounting equation is the basic technique for all firms, regardless of size or goal, to perform double-entry bookkeeping. It illustrates the interaction of the three major parts of the accounting equation: assets, liabilities, and owner’s equity.

Conclusion

In this article, I have discussed three important parts of the accounting equation( assets, liabilities, and shareholder equity) with examples. This article helps you to understand the accounting equation clearly and it also helps you to calculate the total assets of any company or any business.