The Basic Accounting Equation

The fundamental accounting equation, also called the balance sheet equation, represents
the relationship between the assets, liabilities, and owner's equity of a person or business. It
is the foundation for the double-entry bookkeeping systemThe accounting equation is a basic
principle of accounting and a fundamental element of the balance sheet.

The accounting equation is considered to be the foundation of the double-entry accounting

system. The accounting equation shows on a company's balance sheet where by the total of
all the company's assets equals the sum of the company's liabilities and shareholders' equity.
Based on this double-entry system, the accounting equation ensures that the balance sheet
remains “balanced,” and each entry made on the debit side should have a corresponding
entry (or coverage) on the credit side. The accounting equation of a sole proprietorship is
assets = liabilities + owner's equity. For a corporation, the accounting equation is assets =
liabilities + stockholders' equity.

Assets: This is the value of the items that a company owns; they may be tangible or
intangible but belong to the company. What the business has or owns (equipment, supplies,
cash, and accounts receivable). Assets represent the economic resources of the entity
deployed to generate future income. An asset is a resource with economic value that an
individual, corporation, or country owns or controls with the expectation that it will provide
a future benefit. Assets are anything valuable that your company owns, whether it’s
equipment, land, buildings, or intellectual property. Assets mean anything that a
company possesses.

Assets represent the valuable resources controlled by the company. The liabilities represent
their obligations

When you look at your assets, you’re trying to answer a simple question:

"How much do I have?"

If it has value, and you own it, it’s an asset.

Something valuable that an entity owns, benefits from, or has use of, in generating income.
For example, land, building, furniture and fixtures, plant and machinery, vehicles, debtors,
bills receivable, bank balance, cash, stock, etc.

A liability: A liability is something a person or company owes, usually a sum of money.

Liabilities mean everything that the company owes to other people.

This is a term for total value that a company is required to pay in the short term or the long
term. What the business owes outsiders (bank loan, accounts payable). Liabilities are legally
binding obligations that are payable to another person or entity. Liabilities include loans,
accounts payable, mortgages, deferred revenues, and accrued expenses. Liabilities refer to
the amount a business owes to the outsiders. Money that the company owes to others (e.g.
mortgages, vehicle loans). Liabilities are claims against assets. That is liabilities are existing
debts and obligations.
When you look at your accounting software or spreadsheets and look at your liabilities,
you’re asking:

"How much do I owe?"

If you’ve promised to pay someone in the future, and haven’t paid them yet, that’s a liability.

Owner’s Equity’: Shareholders Equity is the amount of money a company has raised
through its issue of shares. The ownership claim on total assts is known as owner’s equity. It
is equal to total assets minus total liabilities.Equity shows the assets that the company
owns outright. Alternatively, it is also the amount of retained earnings of a company. What
the owner owns (investment and business profit). It represents the owner’s own investment
into the business. Extending from the fundamental accounting equation, the owner’s equity
equals the total assets held as reduced by the external liabilities (Assets – Liabilities). For
this reason, it is also referred to as Net Assets. All adjustments for profits, reserves, and
drawings reflect in this account. Equity that portion of the total assets that the owners or
stockholders of the company fully own; have paid for outright: Capital or Owner’s Equity is
the money that the owner brings into the business.

Revenue or Income: Money the company earns from its sales of products or services, and
interest and dividends earned from marketable securities. Revenue is the inflow of assets
arising out of sale of commodities and services.

Expenses: Money the company spends to produce the goods or services that it sells (e.g.
office supplies, utilities, advertising). Amount spent for earning is called expense. Expenses
are the loss of assets consumed or services used in the process of earning revenue. They are
decreases in owner’s equity that result from operation the business.

Transaction:
Any occurrence or incidence is known as event. There are two types of events i) financial
event ii) non-financial event. Financial event is known as transaction. Financial event are
recorded in the books of account as transaction. All business transaction shall have to be
recorded in terms of any monetary units.
The term ‘business transaction’ has been defined as any act that alters the financial position
of a business, where such alteration can be measured in terms of money. Thus, if goods are
purchased for cash Rs. 500 it constitutes a transaction because it alters the financial position
of the concern i.e., total cash resource is reduced by Rs. 500 and goods of the same value are
added to the list of assets. But if it is said that, 20 bags of sugar have been purchased, it
cannot constitute a business transaction until the value of each bag or 20 bags of sugar is
ascertained.
Business transaction means the dealing of a trader in regard to money or money’s worth. It
must necessarily require two accounts or parties for its fulfillment and it involves receipt of a
benefit and the surrender of a similar benefit. The events; cash received and cash payment,
credit purchase and cash sales; and visible or invisible which alter the financial position is
known as transactions.
Accounting to modern theory method every transaction involves only the three balance sheet
elements, assets liabilities and proprietorship, causing increase and decrease in these
elements.
Every event is not transaction but every transaction is an event:

Characteristics of transactions:
(i) Event must be measurable in terms of money: Purchased a pen it is not transaction. An
event in order to be a transaction must be amenable to calculation is terms of money value.
(ii) Financial change must be brought by the events. Bought machinery Tk. 100000. An
event in order to be a transaction must bring financial change in the business.
(iii) There must have two accounts or parties in each transaction: There is no transaction
without two account or parties. If one receives something’s some other person has given it.
An event in order to be transaction must affect a lest to account or parties simultaneously
(iv) Transaction must be independent.

(v) Invisible event: Transaction will be visible it is not necessary. Invisible events may be
transaction depreciation.
(vi) Hysterical event: An event in order to be transaction need not always be historical.

Impact of Transactions on Accounting Equation: (For Examples)

Business Transactions occur on a daily basis as a result of doing business. Items are
purchased or sold, credit is extended or borrowed, income is made or expenses are
assumed. These business transactions result in changes to the three elements of the basic
accounting equation.
1. A transaction that increases total assets must also increase total liabilities or owner’s
equity.
2. A transaction that decreases total assets must also decrease total liabilities or owner’s
equity.
3. Some transactions may increase one account and decrease another on the same side of
the equation i.e. one asset increases and another decreases.

Transaction 1: The owner deposits $50000 in the checking account to begin operations
Assets = Liabilities + Owner’s Equity
+$50000 $0 + $50000
The asset “Cash” is increased by $50000 and the Owner’s Equity is increased $50000. The
business owes the owner $50000.

Transaction 2: The business purchases a computer, on credit, for $25000.

Assets = Liabilities + Owner’s Equity
$25000 = $25000
The asset “Computers” is increased by $25000 and the liability is also increased $25000.

Transaction 3: The business purchases office supplies using $550 cash.

Assets = Liabilities + Owner’s Equity
+$550
-$550
The asset “Office Supplies” is increased $550 and the asset “Cash” is decreased $550.

Transaction 4: A business purchases a building for $100,000 with a $25,000 cash down-
payment and a loan for the $75,000 outstanding.
Assets = Liabilities + Owner’s Equity
+$100,000=$75,000
-$25,000
More than two accounts are affected by this transaction. The asset “Building” increases by
$100,000, the asset “Cash” decreases by $25,000, and the liability “Bank Loan” increases by
$75,000. The net result is that both sides of the equation increase by $75K.

The expanded Accounting Equation looks like this:

Assets = Liabilities + Owner’s Equity + Revenues – Expenses – Drawings
Let’s analyze some transactions involving these types of accounts:

Transaction 5: The business sells goods for $1,2000 cash.

Assets = Liabilities + Owner’s Equity+ Income - Expenses
+$1200 +$12000 (Revenue)
The asset “Cash” is increased $12000 and the revenue is increased $12000.

Transaction 6: The business’ owner withdraws $2,000 for his personal use.
Assets = Liabilities + Owner’s Equity
-$2000 -$2000 (Revenue)
The asset “Cash” is decreased $2000 and the drawing decreases Owner’s Equity $2000.
Transaction 7: The business’ purchases goods for Cash $2,0000.
Assets = Liabilities + Owner’s Equity
-$2000 -$2000 (Revenue)
The asset “Cash” is decreased $20000 and the expenses is also increased by $20000.
 Bottom of Form

The Basic Accounting Equation

An accounting transaction is a business activity or event that causes a measurable change in the accounting
equation. An exchange of cash for merchandise is a transaction. Merely placing an order for goods is not a
recordable transaction because no exchange has taken place. In the coming sections, you will learn more
about the different kinds of financial statements accountants generate for businesses.

In the previous section we described specific types of accounts that business activities fall into, namely:

1. Assets (what it owns)

2. Liabilities (what it owes to others)
3. Equity (the difference between assets and liabilities or what it owes to the owners)

These are the building blocks of the basic accounting equation. The accounting equation is:

ASSETS = LIABILITIES + EQUITY

For Example:

A sole proprietorship business owes $12,000 and you, the owner personally invested $100,000 of your own
cash into the business. The assets owned by the business will then be calculated as:

$12,000 (what it owes) + $100,000 (what you invested) = $112,000 (what the company has in assets)

Assets = Liabilities + Equity

112,000 = 12,000 100,000

In a sole-proprietorship, equity is actually Owner’s Equity. If the business in question is a

corporation, equity will be held by stockholders, which uses stockholder’s equity but the basic equation is
the same:

ASSETS = LIABILITIES + EQUITY

For Example:

A business owes $35,000 and stockholders (investors) have invested $115,000 by buying stock in the
company. The assets owned by the business will then be calculated as:

$35, 000 (what it owes) + $115,000 (what stockholders invested) = $150,000 (what the company has in
assets)

Assets = Liabilities + Equity

150,000 = 35,000 115,000

Since each transaction affecting a business entity must be recorded in the accounting records based on a
detailed account (remember, file folders and the chart of accounts from the previous section), analyzing a
transaction before actually recording it is an important part of financial accounting. An error in transaction
analysis could result in incorrect financial statements.

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.

1. Owners invested cash

Metro Courier, Inc., was organized as a corporation on January 1, the company issued shares (10,000
shares at $3 each) of common stock for $30,000 cash to Ron Chaney, his wife, and their son. The $30,000
cash was deposited in the new business account.

Transaction analysis:

 The new corporation received $30,000 cash in exchange for ownership in common stock (10,000 shares at
$3 each).
 We want to increase the asset Cash and increase the equity Common Stock.

Assets Equity

Transaction Cash Common Stock

1. Owner invested cash + 30,000 + 30,000

Let’s check the accounting equation: Assets $30,000 = Liabilities $0 + Equity $30,000

2. Purchased equipment for cash

Metro paid $ 5,500 cash for equipment (two computers).

Transaction analysis:

 The new corporation purchased new asset (equipment) for $5,500 and paid cash.
 We want to increase the asset Equipment and decrease the asset Cash since we paid cash.

Assets Equity

Transaction Cash Equipment Common Stock

1. Owner invested cash + 30,000 + 30,000

2. Purchased equipment for cash – 5,500 +5,500

Balance: 24,500 5,500 30,000

Let’s check the accounting equation: Assets $30,000 (Cash $24,500 + Equipment $5,500) = Liabilities $0
+ Equity $30,000

3. Purchased truck for cash

Metro paid $ 8,500 cash for a truck.

Transaction analysis:

 The new corporation purchased new asset (truck) for $8,500 and paid cash.
 We want to increase the asset Truck and decrease the asset cash for $8,500.

Assets Equity

Transaction Cash Equipment Truck Common Stock

1. Owner invested cash + 30,000 + 30,000

2. Purchased equipment for cash – 5,500 +5,500

3. Purchased truck for cash -8,500 + 8,500

Balance: 16,000 5,500 8,500 30,000

Let’s check the accounting equation: Assets $30,000 (Cash $16,000 + Equipment $5,500 + Truck $8,500) =
Liabilities $0 + Equity $30,000

4. Purchased supplies on account.

Metro purchased supplies on account from Office Lux for $500.

Transaction analysis:

 The new corporation purchased new asset (supplies) for $500 but will pay for them later.
 We want to increase the asset Supplies and increase what we owe with the liability Accounts Payable.

Assets = Liabilities + Equity

Transaction Cash Supplies Equipment Truck Accounts Payable Common Stock

1. Owner invested cash + 30,000 + 30,000

2. Purchased equipment for cash – 5,500 +5,500

3. Purchased truck for cash -8,500 + 8,500

4. Purchased supplies on account. + 500 + 500

Balance: 16,000 500 5,500 8,500 500 30,000

Let’s check the accounting equation: Assets $30,500 (Cash $16,000+ Supplies $500 + Equipment $5,500 +
Truck $8,500) = Liabilities $500 + Equity $30,000

5. Making a payment to creditor.

Metro issued a check to Office Lux for $300 previously purchased supplies on account.
Transaction analysis:

 The corporation paid $300 in cash and reduced what they owe to Office Lux.
 We want to decrease the liability Accounts Payable and decrease the asset cash since we are not buying new
supplies but paying for a previous purchase.

Assets = Liabilities + Equity

Transaction Cash Supplies Equipment Truck Accounts Payable Common Stock

1. Owner invested cash + 30,000 + 30,000

2. Purchased equipment for cash – 5,500 +5,500

3. Purchased truck for cash -8,500 + 8,500

4. Purchased supplies on account. + 500 + 500

5. Making a payment to creditor. -300 -300

Balance: 15,700 500 5,500 8,500 200 30,000

Let’s check the accounting equation: Assets $30,200 (Cash $15,700 + Supplies $500 + Equipment $5,500 +
Truck $8,500) = Liabilities $200 + Equity $30,000

6. Making a payment in advance.

Metro issued a check to Rent Commerce, Inc. for $1,800 to pay for office rent in advance for the months of
February and March.

Transaction analysis (to save space we will look at the effects of each of the remaining transactions only):

 The corporation prepaid the rent for next two months making an advanced payment of $1,800 cash.
 We will increase an asset account called Prepaid Rent (since we are paying in advance of using the rent) and
decrease the asset cash.

Assets

Transaction Cash Prepaid Rent

Previous Balance $ 15,700

6. Making a payment in advance. -1,800 + 1,800

Balance: 13,900 1,800

The only account balances that changed from transaction 5 are Cash and Prepaid Rent. All other account
balances remain unchanged. The new accounting equation would be: Assets $30,200 (Cash $13,900 +
Supplies $500 + Prepaid Rent $1,800 + Equipment $5,500 + Truck $8,500) = Liabilities $200 + Equity
$30,000

7. Selling services for cash.

During the month of February, Metro Corporation earned a total of $50,000 in revenue from clients who
paid cash.

Transaction analysis:

 The corporation received $50,000 in cash for services provided to clients.

 We want to increase the asset Cash and increase the revenue account Service Revenue.

Assets Revenues

Transaction Cash Service Revenue

Previous Balance $ 13,900

7. Selling services for cash . + 50,000 + 50,000

Balance: $ 63,900 $ 50,000

Wait a minute…the accounting equation is ASSETS = LIABILITIES + EQUITY and it does not have
revenue or expenses…where do they fit in? Revenue – Expenses equals net income. Net Income is added
to Equity at the end of the period. Assets $80,200 (Cash $63,900 + Supplies $500 + Prepaid Rent $1,800 +
Equipment $5,500 + Truck $8,500)= Liabilities $200)+ Equity $80,000 (Common Stock $30,000 + Net
Income $50,000). Note: This does not mean revenue and expenses are equity accounts!

8. Selling services on credit.

Metro Corporation earned a total of $10,000 in service revenue from clients who will pay in 30 days.

Transaction analysis:

 Metro performed work and will receive the money in the future.
 We record this as an increase to the asset account Accounts Receivable and an increase to service revenue.

Assets Revenues

Transaction Accounts Receivable Service Revenue

Previous Balance $ 50,000

8. Selling services on credit. + 10,000 + 10,000

Balance: $ 10,000 $ 60,000

Remember, all other account balances remain the same. The only changes are the addition of Accounts
Receivable and an increase in Revenue. Assets $90,200 (Cash $63,900 + Accounts Receivable $10,000 +
Supplies $500 + Prepaid Rent $1,800 + Equipment $5,500 + Truck $8,500)= Liabilities $200 + Equity
$90,000 (Common Stock $30,000 + Net Income $60,000).

9. Collecting accounts receivable.

Metro Corporation collected a total of $5,000 on account from clients who owned money for services
previously billed.
Transaction analysis:

 Metro received $5,000 from customers for work we have already billed (not any new work).
 We want to increase the asset Cash and decrease (what we will receive later from customers) the asset
Accounts Receivable.

Assets

Transaction Cash Accounts Receivable

Previous Balance $ 63,900 $ 10,000

9. Collecting accounts receivable. + 5,000 – 5,000

Balance: $ 68,900 $ 5,000

Assets $90,200 (Cash $68,900 + Accounts Receivable $5,000 + Supplies $500 + Prepaid Rent $1,800 +
Equipment $5,500 + Truck $8,500)= Liabilities $200 + Equity $90,000 (Common Stock $30,000 + Net
Income $60,000).

10. Paying office salaries.

Metro Corporation paid a total of $900 for office salaries.

Transaction analysis:

 The corporation paid $900 to its employees.

 We will increase the expense account Salaries Expense and decrease the asset account Cash.

Assets Expenses

Transaction Cash Salary Expense

Previous Balance $ 68,900

10. Paying Office Salaries. – 900 + 900

Balance: $ 68,000 $ 900

Remember, net income is calculated as Revenue – Expenses and is added to Equity. The new accounting
equation would show: Assets $89,300 (Cash $68,000 + Accounts Receivable $5,000 + Supplies $500 +
Prepaid Rent $1,800 + Equipment $5,500 + Truck $8,500)= Liabilities $200 + Equity $89,100 (Common
Stock $30,000 + Net Income $59,100 from revenue of $60,000 – expenses $900).

11. Paying utility bill.

Metro Corporation paid a total of $1,200 for utility bill.

Transaction analysis:

 The corporation paid $1,200 in cash for utilities.

 We will increase the expense account Utility Expense and decrease the asset Cash.
 Assets Expense

Transaction Cash Utilities Expense

Previous Balance $ 68,000

11. Paying Utility Bill – 1,200 + 1,200

Balance: $ 66,800 $ 1,200

Click Transaction analysis to see the full chart with all transactions. The final accounting equation would
be: Assets $88,100 (Cash $66,800 + Accounts Receivable $5,000 + Supplies $500 + Prepaid Rent $1,800 +
Equipment $5,500 + Truck $8,500) = Liabilities $200 + Equity $87, 900 (Common Stock $30,000 + Net
Income $57,900 from revenue of $60,000 – salary expense $900 – utility expense $1,200).

Answer the following questions about the accounting equation. Remember to rate your confidence to check
your answer: Maybe? Probably. Definitely!

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