2 4: The Basic Accounting Equation Business LibreTexts

To learn more about the balance sheet, see our Balance Sheet Outline. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

4: The Basic Accounting Equation

The balance sheet reports a company’s assets, liabilities, and owner’s (or stockholders’) equity at a specific point in time. Like the accounting equation, it shows that a company’s total amount of assets equals the total amount of liabilities plus owner’s (or stockholders’) equity. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill.

Producing the Financial Statements

Accrued expenses occur when you record an expense even if it is not yet paid. It’s important to accrue expenses so that you record them in the proper accounting period, even if you delay payment until the next accounting period. Common examples of accrued expenses would be payroll accruals or accrued rent expenses.

• If assets increase, either liabilities or owner’s equity must increase to balance out the equation.
• Therefore cash (asset) will reduce by $60 to pay the interest (expense) of $60.
• For all recorded transactions, if the total debits and credits for a transaction are equal, then the result is that the company’s assets are equal to the sum of its liabilities and equity.
• Let’s take a look at the formation of a company to illustrate how the accounting equation works in a business situation.
• We show formulas for how to calculate it as a basic accounting equation and an expanded accounting equation.

Additional Resources

In Double-Entry Accounting, there are at least two sides to every financial transaction. Every accounting entry has an opposite corresponding entry in a different account. This principle ensures that the Accounting Equation stays balanced. So, let’s take a look at every element of  the accounting equation. This number is the sum of total earnings that were not paid to shareholders as dividends. In worst-case scenarios, the company could go bankrupt as a result of mishandling finances using inaccurate numbers due to an unbalanced equation.

What is your current financial priority?

Metro issued a check to Office Lux for $300 previously purchased supplies on account. Metro purchased supplies on account from Office accounting equation broken down Lux for $500. Our popular accounting course is designed for those with no accounting background or those seeking a refresher.

The Accounting Equation: What It Is & The Effects of Common Transactions

Customers and vendors can be sources of liabilities for operations. Paying taxes, fees, permits, and salaries are liabilities once they become due but aren’t yet paid. It too provides a source of funding but is different from a liability because no repayment obligation exists. Retained earnings are all the profits made to date but unpaid to the owners in the form of dividends. Because profits are generated for the shareholders, retained earnings is theoretically due to the business owners. It is important to understand the definitions of each component in the equation.

Ask a Financial Professional Any Question

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Example Transaction #3: Purchase of Supplies on Credit

The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). For a company keeping accurate accounts, every business transaction will be represented in at least two of its accounts. For instance, if a business takes a loan from a bank, the borrowed money will be reflected in its balance sheet as both an increase in the company’s assets and an increase in its loan liability. Let us imagine a business is set up and enters into a series of transactions over the first period. All transactions are recorded by the accounting system and used to produce an income statement, balance sheet and cash flow statement. The basic formula of accounting equation formula is assets equal to liabilities plus owner’s equity.

Ask Any Financial Question

• The formula defines the relationship between a business’s Assets, Liabilities and Equity.
• The company acquired printers, hence, an increase in assets.
• The additional amount above par is reported in an account called additional paid-in capital or share premium.
• The accounting equation is not always accurate if it is unbalanced.
• This equation is the foundation of modern double entry system of accounting being used by small proprietors to large multinational corporations.