The accounting equation is the unifying concept in accounting that shows the relationships between and among the accounting elements: assets, liabilities, and capital.
Before taking this lesson, be sure to be familiar with the accounting elements.
The basic accounting equation is:
Assets = Liabilities + Capital
When a business is put up, its resources (assets) come from two sources: contributions by owners (capital) and those acquired from creditors or lenders (liabilities).
In other words, all assets initially come from liabilities and owners' contributions.
As business transactions take place, the values of the accounting elements change. The accounting equation nonetheless always stays in balance.
Every transaction has a two-fold effect. Meaning, at least two accounts are affected. Let's illustrate all of that through these examples.
Assume the following transactions:
How will the transactions affect the accounting equation?
| Transaction | Assets | = | Liabilities | + | Capital |
|---|---|---|---|---|---|
| 1. Owner's investment | 20,000.00 | = | + | 20,000.00 |
Again, every transaction has a two-fold effect. In the above transaction, Assets increased as a result of the increase in Cash. At the same time, Capital increased due to the owner's contribution. Remember that capital is increased by contribution of owners and income, and is decreased by withdrawals and expenses. No liability is affected hence, stays at zero.
| Transaction | Assets | = | Liabilities | + | Capital |
|---|---|---|---|---|---|
| 1. Owner's investment | 20,000.00 | = | + | 20,000.00 | |
| 2. Loan from bank | 30,000.00 | = | 30,000.00 | + |
In transaction #2, the company received cash. Thus, the value of total assets is increased. At the same time, it incurred in an obligation to pay the bank. Therefore, liabilities are increased. The liability in this case is recorded as Loans Payable.
Notice that the accounting equation is still equal (balanced).
| Transaction | Assets | = | Liabilities | + | Capital |
|---|---|---|---|---|---|
| 1. Owner's investment | 20,000.00 | = | + | 20,000.00 | |
| 2. Loan from bank | 30,000.00 | = | 30,000.00 | + | |
| 3. Purchased printers | 1,000.00 (1,000.00) |
= | + |
The company acquired printers, hence, an increase in assets. However, the company used cash to pay for the printers. Thus, it also results in a decrease in assets. Transaction #3 results in an increase in one asset (Service Equipment) and a decrease in another asset (Cash).
For those who are new to accounting format: The parentheses "()" around the 1,000 amount above means "minus" or "less".
Liabilities and capital were not affected in transaction #3. Still, the equation in this transaction is equal. It resulted to a zero effect in both sides.
At this point, the balance of total assets is $50,000. The combined balance of liabilities and capital is also at $50,000.
As illustrated above, the accounting equation is (and should always be) in balance. Here are some more examples you could study: Accounting Equation: More Examples.
The accounting equation states that total assets is equal to total liabilities plus capital. This lesson presented the basic accounting equation and how it stays equal. Be sure to check out the expanded accounting equation too.
