Lesson 10: Accounting Equation
In this lesson, we will learn the basic formula, assets = liabilities + equity.
After completing the lesson, we will understand the fundamentals of the
accounting equation and the rules that dictate the equation. We will finish by
looking at some 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.
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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.
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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.
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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:
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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:
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Transaction Example 1
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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 2Â
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
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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.
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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.