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Do You Know The Basics of Accounting Equation

The Accounting Equation is the simplest form of a balance sheet or statement of financial position. Whenever the business incurs a transaction, it affects the accounting equation in two ways, left the side of the equation and right side of the equation. Both of these effects must be recorded.

Accounting equation can be represented as follows:

Assets= Equity + Liabilities

OR

Equity= Assets – Liabilities

OR

Equity= Net Assets

Do you Know?

The above representation of the accounting equation is also called an ‘accounting equation formula’. Do you know the 3 basic definitions of accounting?

Definition of Accounting Equation

Total assets of an entity must be equal to the sum of equity and liabilities.

OR

Equity of an entity must be equal to its assets fewer liabilities

OR

Equity of an entity must be equal to net assets.

Accounting Equation Examples:

Now, it’s time to explain our concept of accounting equation with some examples.

Example 1:

Suppose Jack sets up a new business with the name “Jack’s spares & stores”. He injects a capital of $20,000 into the bank account of the newly built business. This is a business transaction, as it has a monetary effect on the financial statements of the entity. This transaction has two effects, bank balance increased by $20,000 and capital/equity of the owner also increased by $20,000. We will represent this business transaction in our equation as follows:

Assets =        Equity    +   Liabilities

$20,000 =    $20,000 +   0

Example 2:

Suppose Jack borrows an amount of $10,000 from his brother Daniel to buy a delivery van for his business. This transaction has two effects:

  1. Assets side will increase by $10,000 because Jack will buy a delivery van for his business. (the Delivery van is an asset)
  2. Liability side will also increase by $10,000 because ‘Jack spares & Parts’ has now an obligation to pay $10,000 to Daniel.

These effects must be recorded. We can represent them in the accounting equation formula as follows:

Assets    =     Equity +   Liabilities

$10,000 =     0        +     $10,000

Example 3:

Suppose Jack spends $5,000 from his bank account and purchase some spares & pars for the business. This transaction has two effects:

  1. Assets of the business decreased by $5,000, and
  2. Assets of the business also got increased by $5,000.

What was this?  This transaction was simply the use of one asset to buy another asset. This is what you may call “Make-Up of Assets”, as there was no change in the net assets.

We can represent the transaction in our equation as follows:

Assets =   Equity +    Liabilities

0          =   $5,000 +   $5,000

 

How to Calculate the Accounting Equation:

Accounting equation of any entity can be calculated in the following 5 steps:

  1. Take the statement of financial position or balance sheet of your desired entity.
  2. Copy the total amount of assets and put it in our accounting equation formula.
  3. Copy the owner’s equity and paste it in our equation.
  4. Copy the total liabilities of the entity and paste it in our equation.
  5. You can see, the total of assets must be equal to the sum of equity and liabilities.

 Example:

Let me show you the above steps with the help of an example:

I’m going to calculate the accounting equation for Amazon. I downloaded their annual reports which includes balance sheet from their official website.

how to calculate accounting equation - Do You Know The Basics of Accounting Equation
Calculating the accounting equation from amazon’s balance sheet

You can see, the total assets of Amazon are $131,310.

Similarly, total liabilities are $57,883+$24,743+$20,975= $103,601

Amazon have equity of $27,709.

Now, let me put all this information into our equation:

Assets = Equity + Liabilities

$131,310 = $27,709 + $103,601

$131,310= $131,310

You can see, both sides of our equation are matched.

How to Use the Accounting Equation?

As evident from the above examples, a change on one side of the equation must be matched by a change on the other side of the equation. This is why an increase in equity must be matched with an increase in equity or an increase in liability. Similarly, a decrease in assets must be matched by a decrease in equity or liabilities. Accounting equation has the following uses:

  • It is the foundation of double entry bookkeeping. It ensures the correct double entry in our books of accounts.
  • It keeps our balance sheet or statement of financial position balanced.
  • It helps us assess whether all the business transactions have been recorded in the books of accounts.
  • It tells us where a business stands at a particular point in time. This way it lays out the foundation for balance sheet or statement of financial position.

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