Accounting equation

Categories: Accounting

Basic accounting equation is the foundation for the whole double-entry book-keeping system.

Contents 1 The equation 2 Re-write 3 How it works 4 Balance sheet

The equation

The equation is as follows:

<math>Assets=Liabilities+Shareholders'\ Equity</math>

It shows how assets were financed: either by borrowing money from someone else (liability) or by paying your own money shareholder's equity. For example, a student buys a computer for $945. This student borrowed $500 from his best friend and saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.

Re-write

If formula is re-written in this manner:

<math>Assets-Liabilities=Shareholder's\ Equity</math>

Now it shows that owner's interest is equal to property (assets) minus debts (liabilities). Since in a company owners are shareholders, owner's interest is called shareholder's equity.

How it works

Every accounting transaction affects at least one element of the equation but always balances. Simplest transactions include:

Transaction    Assets        = Liabilities + Shareholder's equity
    1.         + 6.000                         +6.000
    2.         +10.000          +10.000
    3.         +   900  -900
    4.         + 1.000  -450    +   550
    5.         +   700                         +  700
    6.         -   200                         -  200
    7.                          +   100        -  100
    8.         -   500          -   500
    9.         +   200   -200

Explanation of transactions:

1. issuing stocks for cash or other assets;
2. buying assets by borrowing money (taking a loan from a bank or simply buying on credit);
3. buying assets for cash (in essence, it's just an exchange of one asset to another);
4. buying assets by paying cash and by borrowing money;
5. earning revenues;
6. paying expenses (e.g., rent or professional fees) or dividends;
7. recording expenses, but not paying them at the moment.
8. paying on a debt that you owe
9. received cash for sale of an asset

These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.

Balance sheet

An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity and makes sure it balances (thus the name of balance sheet).