Definition of the Accounting Equation
The accounting equation shows the relationship between assets, liabilities and equity. It is the basis upon which the double entry accounting system is constructed. In essence, the accounting equation is:
Assets = Liabilities + Shareholders' Equity
The company pays for these resources by either incurring liabilities (which is the Liabilities part of the accounting equation) or by obtaining funding from investors (which is the Shareholders' Equity part of the 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 Liabilities part of the equation is usually comprised of accounts payable that are owed to suppliers, a variety of accrued liabilities, such as sales taxes and income taxes, and debt payable to lenders.
The Shareholders' Equity part of the equation is more complex than simply being the amount paid to the company by investors. It is actually their initial investment, plus any subsequent gains, minus any subsequent losses, minus any dividends or other withdrawals paid to the investors.
You can see this relationship between assets, liabilities, and shareholders' equity in the balance sheet, where the total of all assets always equals the sum of the liabilities and shareholders' equity sections.
The reason why the accounting equation is so important is that it is always true - and it forms the basis for all accounting transactions. At a general level, this means that whenever there is a recordable transaction, the choices for recording it all involve keeping the accounting equation in balance. The accounting equation concept is built into all accounting software packages, so that all transactions that do not meet the requirements of the equation are automatically rejected.
Accounting Equation Example
ABC International engages in the following series of transactions:
ABC sell shares to an investor for $10,000. This increases the cash (asset) account as well as the capital (equity) account.
ABC buys $4,000 of inventory from a supplier. This increases the inventory (asset) account as well as the payables (liability) account.
ABC sells the inventory for $6,000. This decreases the inventory (asset) account and creates a cost of goods sold expense that appears as a decrease in the income (equity) account.
The sale of ABC's inventory also creates a sale and offsetting receivable. This increases the receivables (asset) account by $6,000 and increases the income (equity) account by $6,000.
ABC collects cash from the customer to which it sold the inventory. This increases the cash (asset) account by $6,000 and decreases the receivables (asset) account by $6,000.
These transactions appear in the following table:
Note how every transaction is balanced within the accounting equation - either because there are changes on both sides of the equation, or because a transaction cancels itself out on one side of the equation (as was the case when the receivable was converted to cash).
Recording accounting transactions with the accounting equation means that you use debits and credits to record every transaction, which is known as double-entry bookkeeping.
The following table shows how a number of typical accounting transactions are recorded within the framework of the accounting equation:
|Transaction Type||Assets||Liabilities + Equity|
|Buy fixed assets on credit||Fixed assets increase||Accounts payable (liability) increases|
|Buy inventory on credit||Inventory increases||Accounts payable (liability) increases|
|Pay dividends||Cash decreases||Retained earnings (equity) decreases|
|Pay rent||Cash decreases||Income (equity) decreases|
|Pay supplier invoices||Cash decreases||Accounts payable (liability) decreases|
|Sell goods on credit (part 1)||Inventory decreases||Income (equity) decreases|
|Sell goods on credit (part 2)||Accounts receivable increases||Income (equity) increases|
|Sell services on credit||Accounts receivable increases||Income (equity) increases|
|Sell stock||Cash increases||Equity increases|
Here are examples of each of the preceding transactions, where we show how they comply with the accounting equation:
Buy fixed assets on credit. ABC Company buys a machine on credit for $10,000. This increases the fixed assets (Asset) account and increases the accounts payable (Liability) account. Thus, the asset and liability sides of the transaction are equal.
Buy inventory on credit. ABC Company buys raw materials on credit for $5,000. This increases the inventory (Asset) account and increases the accounts payable (Liability) account. Thus, the asset and liability sides of the transaction are equal.
Pay dividends. ABC Company pays $25,000 in dividends. This reduces the cash (Asset) account and reduces the retained earnings (Equity) account. Thus, the asset and equity sides of the transaction are equal.
Pay rent. ABC Company pays $4,000 in rent. This reduces the cash (Asset) account and reduces the accounts payable (Liabilities) account. Thus, the asset and liability sides of the transaction are equal.
Pay supplier invoices. ABC Company pays $29,000 on existing supplier invoices. This reduces the cash (Asset) account by $29,000 and reduces the accounts payable (Liability) account. Thus, the asset and liability sides of the transaction are equal.
Sell goods on credit. ABC Company sell goods for $55,000 on credit. This increases the accounts receivable (Asset) account by $55,000, and increases the revenue (Equity) account. Thus, the asset and equity sides of the transaction are equal.
Sell stock. ABC Company sells $120,000 of its shares to investors. This increases the cash account (Asset) by $120,000, and increases the capital stock (Equity) account. Thus, the asset and equity sides of the transaction are equal.
Additional Accounting Equation Issues
What if you print the balance sheet and the total of all assets do not match the total of all liabilities and shareholders' equity? There may be one of three underlying causes of this problem:
Rounding error. If your accounting software is rounding to the nearest dollar or thousand dollars, the rounding function may result in a presentation that appears to be unbalanced.
Unbalanced starting numbers. If you have just started using the software, you may have entered beginning balances for the various accounts that do not balance under the accounting equation. The accounting software should flag this problem when you are entering the beginning balances.
Unbalanced transactions. You may have made a journal entry where the debits do not match the credits. This should be impossible if you are using accounting software, but is entirely possible (if not likely) if you are recording accounting transactions manually.
Nonprofit Accounting Equation
The equation differs for a nonprofit entity, since a nonprofit does not record any shareholders' equity. Instead, the equation for a nonprofit is as follows:
Assets = Liabilities + Net Assets
The net assets part of this equation is comprised of unrestricted and restricted net assets.