Accounting Equation: Short Note with Example
The accounting equation is the foundation of the double-entry bookkeeping system. It demonstrates the
relationship between a company's assets, liabilities, and equity. It states that:
Assets = Liabilities + Equity
Explanation:
• Assets: What the company owns. Resources with future economic value (e.g., cash, accounts
receivable, inventory, equipment, buildings).
• Liabilities: What the company owes to others. Obligation to pay money or provide services in the
future (e.g., accounts payable, salaries payable, loans payable).
• Equity: The owners' stake in the company. Represent the residual value of the assets after deducting
liabilities. (e.g., common stock, retained earnings).
Why it Matters:
• Balance: The equation must always balance. Every transaction affects at least two accounts, ensuring
that the equation remains in equilibrium.
• Foundation: It underlies all accounting transactions and financial statements.
• Analysis: It helps analyze the financial health and stability of a company.
Example:
Let's say a small business, "Fresh Juice," starts its operations. Here are a few transactions and how they
affect the accounting equation:
1. Transaction 1: Initial Investment
• The owner, Alex, invests $50,000 cash into the business.
• Assets: Cash increases by $50,000.
• Equity: Owner's equity (Common Stock) increases by $50,000.
• Equation: $50,000 (Assets) = $0 (Liabilities) + $50,000 (Equity)
2. Transaction 2: Purchase of Equipment
• Fresh Juice buys equipment for $10,000 cash.
• Assets: Cash decreases by $10,000, and Equipment increases by $10,000.
• Liabilities: No change.
• Equity: No change.
• Equation: $40,000 (Cash) + $10,000 (Equipment) = $0 (Liabilities) + $50,000 (Equity)
×Simplifies to× $50,000 (Assets) = $0 (Liabilities) + $50,000 (Equity)
3. Transaction 3: Purchase of Inventory on Credit
• Fresh Juice purchases juice ingredients (inventory) worth $5,000 on credit (meaning they'll pay later).
• Assets: Inventory increases by $5,000.
• Liabilities: Accounts Payable (what they owe to suppliers) increases by $5,000.
• Equity: No change.
• Equation: $40,000 (Cash) + $10,000 (Equipment) + $5,000 (Inventory) = $5,000 (Liabilities) + $50,000
(Equity)
×Simplifies to× $55,000 (Assets) = $5,000 (Liabilities) + $50,000 (Equity)
4. Transaction 4: Revenue and Expenses
• Fresh Juice sells juice for $12,000 in cash. Cost of the juice sold is $4,000
• Assets: Cash increases by $12,000, Inventory decreases by $4,000.
• Liabilities: No change
• Equity: Revenue increases retained earnings by 12,000 and Cost of Goods Sold (an expense)
decreases retained earnings by 4,000, for a net increase of 8,000.
• Equation: $52,000 (Cash) + $10,000 (Equipment) + $1,000 (Inventory) = $5,000 (Liabilities) + $58,000
(Equity)
×Simplifies to× $63,000 (Assets) = $5,000 (Liabilities) + $58,000 (Equity)
Key takeaway: The accounting equation demonstrates that a company's assets are financed by either
borrowing (liabilities) or by the owners' investments (equity). Every transaction changes the specific
asset, liability, or equity accounts, but the equation remains balanced.
