Lesson Objectives:- Explaining the basic formula: Assets = Liabilities + Equity
- Understanding the fundamentals of the accounting equation
- Rules that dictate the equation
- Transaction examples
We looked at the financial accounting equation a bit when looking at assets, liabilities and equity, now let's break down the underlying concepts behind the equation. This equation is a true representation of the financial accounting elements recorded within the company.
Every transaction influences the financial position of the company. The financial accounting equation helps us to understand the need for accurate record-keeping as one transaction can affect two or more accounts. For example, when a company uses cash to purchase inventory, they are subtracting from their cash assets and their amount of inventory will subsequently increase.
We can virtually post every economic event that happens within a company in this one formula: Assets = Liabilities + Owners' Equity.
This equation reflects the fact that assets are acquired by taking on liabilities or increasing equity as a result of offering shares in the company. The reason that this equation exists is because we receive assets by taking on liabilities and retaining equity.
Assets are the largest amount as they are the sum of the debts and residual value. If liabilities held the most weight, the company would be in an extremely negative position. They would always be in debt and there would never be residual value left for the owners.
While we've seen the equation is fairly straightforward, there are two important things we must keep in mind. Here are the rules that apply to the financial accounting equation:
When performing the equation, it must always balance. This means that the left side of the equation (assets) must be equal to the right side (liabilities + equity). Although, keep in mind that just because the equation balances, that doesn't mean that all transactions are 100 percent accurate.
All transactions must be reflected within the equation, meaning all categories should be accounted for.
Here are three examples of how the accounting equation can be applied in the world of accounting:
Transaction Example 1
The company is purchasing a piece of property with cash for $260,000 and receiving an asset equated at $260,000. The cash is subtracted and an asset is added to the left side of the equation. This example only affected the Assets of the business so all transactions occurred on one side of the equation. If the company had acquired a note to pay for the property instead of using all cash then there would a been an entry on both sides of the equation.
Transaction Example 2
The company is issuing common stock shares worth $200,000, which is recorded as an inflow of assets (cash) on the left side of the equation and on the right side of the equation they receive $200,000 in equity.
Transaction Example 3
An investment in the stock of another company is valued at $50,000, the cash is subtracted on the assets side while also adding in the asset of the $50,000 investment. An investment in another company is considered an asset to the purchasing company and is not reflected in the equity section of the equation.
As you can see, each example balances out on both sides. The double entry accounting system is reflected in these examples as the equation requires two or more entries to balance out. This doesn't need to be a truly symmetrical balance, in which each element is the same, but the amounts must balance on both sides.