Accounting Equation

Accounting equation is the relation between the assets, liabilities and equity of a business. It states that at any point of time, the value of assets of a business is equal to sum of the value of its liabilities and its shareholders' equity.

Assets = Liabilities + Shareholders' Equity

It is the most basic principle of financial accounting and it underlies the double entry accounting.

When entrepreneurs set up a business, the assets of the business (such as office equipment, inventories, cash, etc.) come from two sources. They are either purchased using cash invest in the business by the owners (i.e. equity), or they are purchased using loans obtained from third parties (i.e. liabilities). This is the essence of the accounting equation. This also holds true for additional investments of capital made or additional loans obtained.

An asset is a resource controlled by a business which is of economic use to the business. Examples of assets include land, buildings, vehicles, inventory, accounts receivable, cash and cash equivalents, etc.

A liability is the obligation of a business towards its creditors i.e. those who provided loaned cash or loaned assets. Settlement of liabilities result in an outflow of assets. Common liabilities are accounts payable, salaries payable, taxes payable, etc.

The equity is the claim of the owners of the business on the business' assets. It represents the assets leftover after all liabilities have been paid off. Owner's equity contains accounts such as common stock, retained earnings, etc. The accounting equation can be modified to define shareholders' equity as follows:

Shareholders' Equity = Assets − Liabilities

Example

The following example further explains the concept behind the accounting equation:

In June 20X3, Kumar Sangakara started a tourism business with LKR 15 million in personal savings. Out of the money he invested, he purchased office building worth LKR 10 million and office equipment worth LKR 3 million. He kept LKR 2 million in cash to pay routine expenditures and obtained 10 vehicles from Marwan Atapatu Bank (MAB) for total value of LKR 20 million.

Let's see how these transactions fit into the accounting equation as at the end of first month of operations:

The business assets are: vehicles worth LKR 20 million, office buildings worth LKR 10 million, office equipment worth LKR 3 million, and cash worth LKR 2 million. This sums up to LKR 35 million.

The only liability is the amount payable to MAB on account of leased vehicles amounting to LKR 20.

His shareholders equity which represents his interested in the business is equal to his initial investment plus any profits earned. Since there are no operations and no profit and loss earned in first month, his initial investment assets at LKR 15 million.

This fits well into the accounting equation:

Assets (LKR 35 million) = Liabilities (LKR 20 million) + Equity (LKR 15 million).

There is no transaction that can imbalance this fundamental accounting identity. The concept of expanded accounting equation further helps with how various business transactions are reflected by the accounting equation.