The relationship of assets with that of liabilities and owner’s equity is known as the accounting equation or balance sheet equation. The accounting equation serves as the basic foundation for the accounting systems of all forms of businesses.
The basic accounting equation is as follows:
Assets = Liabilities + Owners’ equity
The sum of the assets of an entity is always equal to the total liabilities plus owners’ equity.
Given any two amounts, the accounting equation may be solved for the third unknown amount.
To illustrate, if the assets owned by a business amount to INR 100,000 and the liabilities amount to INR 40,000, the owner’s equity is equal to INR 60,000, as shown below.
Assets – Liabilities = Owner’s Equity
INR 100,000 – INR 40,000 = INR 60,000
The accounting equation helps to explain that all transactions must balance. Transactions result in changes in assets, liabilities, and owners’ equity.
Even though the elements of the equation change as a result of transactions, the basic equality of the accounting equation remains unchanged.
The two-fold effect of each transaction affects in such a manner that the equality of both sides of the equation is maintained. The two-fold effect in respect of all transactions must be duly recorded in the book of accounts of the business.
In fact, this concept forms the core of the Double Entry System of accounting.
Net assets equal assets minus liabilities. If you do some algebra and subtract liabilities from both sides of the previous equation, you get this formula:
Assets – Liabilities = Owners’ equity
Net assets = Owners’ equity
Elements of Accounting Equation
Before going any further, acquaint yourself with the cast of characters in the equation:
Assets are the resources a company owns. Assets are used by the company in its operations to generate sales and profits. Some examples are;
1. cash and cash equivalent
2. inventories (goods held for sale),
3. land, buildings, and equipment
4. patents, trademarks, and copyrights
Liabilities are obligations or debts that the company has to pay at some time in the future. Some examples of these obligations are;
1. amounts owed to suppliers for goods or services bought on credit,
2. borrowed money (e.g., money owed on bank loans),
3. salaries and wages owed to employees,
4. taxes owed to the government, and services to be performed
Owners’ equity represents the claims by the owner of a business to the assets of the business. Theoretically, the owners’ equity is what would be left if all liabilities were paid, and it is sometimes said to equal net assets.
Some examples that represent owners’ equity;
- General reserves
Why the Accounting Equation is also called the Balance Sheet Equation?
The asset side of the balance sheet is the list of assets, which the business entity owns. The liabilities side of the balance sheet is the list of owner’s claims and outsider’s claims, i.e., what the business entity owes.
The equality of the assets side and the liabilities side of the balance sheet is an undeniable fact and this justifies the name of the accounting equation as balance sheet equation also.
See the Guru Dev Motors’ balance sheet;
Total Asset (INR 254230) = Total Liabilities (INR 110850) + Total Equity (INR 143380)
Effect of Transactions on the Accounting Equation
All business transactions can be stated in terms of changes in the elements of the accounting equation.
Each business transaction can affect the accounting equation in one of the following ways:
To know the influence of a transaction on the accounting equation. Always ask yourself the following three questions before you determine the effect of a transaction on the equation:
a. Which two accounts are involved in the transaction?
b. What type of accounts are they (asset, liability, income or expense)?
c. Did the asset, liability, income or expense increase or decrease?
Examples [Effect of Transactions]
Let’s see some examples, how business transactions affect the accounting equation.
1. Transactions with assets and liabilities
a. Rahul started a business and deposited Rs. 6000000 cash in the bank account of the business
b. He purchased land and buildings for Rs. 2000000.
c. He purchased equipment for Rs. 10 000.
d. He purchased furniture on credit from X, Rs. 15 000.
Effect of above transactions on the equation
Explanation of above Transactions:
The transaction (a) increases the asset cash at bank (on the right side of the equation) by Rs. 60,00,000. To balance the equation, the owner’s equity (on the left side of the equation) increases by the same amount. The equity of the owner is identified using the owner’s name and “Capital,” such as “Rahul’s Capital.”
Owner’s Equity = Assets – Liabilities
Rahul’s Capital (Rs. 60,00,000) = Cash at Bank (Rs. 60,00,000)
In the transaction (b), the purchase of the land & building changes the makeup of the assets, but it does not change the total assets. This transaction decreases the cash at bank by Rs. 20,00,000 and increases the land & building by Rs. 20,00,000.
Owner’s Equity = Assets – Liabilities
Rahul’s Capital (Rs. 60,00,000) = Cash at Bank (Rs. 40,00,000) + Land & Building (Rs. 20,00,000)
- Transactions with income and expenses
a. Bought stationery from the Star Traders on credit, Rs. 500.
b. Paid salaries of personnel, Rs. 8000.
c. Received interest on investment from the bank, Rs.800
d. Paid the water and electricity bills by cheque, Rs. 1300.