Accounting equation

We have learnt in chapter balance sheet that an entity’s financial position is represented by the following three elements:

  • Assets (resources owned by an entity)
  • Liabilities (what an entity owes to others)
  • Owner’s equity or shareholders’ equity (difference between assets and liabilities)

Accounting equation is a mathematical relationship between assets, liabilities, and equity. This equation will always be in balance if the accounting is done properly as per double-entry accounting system. In other words, if you see that the equation is not in balance, it means that there is some error in the accounting records that needs to be rectified. The accounting equation is given below:

Assets = *Equity + Liabilities

* For sole proprietorships, it will be owner’s equity, whereas for corporations, it will be shareholders’ equity.

 Let’s use the example of previous chapter, Journal entries and general ledger and see the impact of those transaction on the accounting equation.

Example

Mr. Arteta started a business related to IT services by incorporating a new company on 1 July 20xx with an initial capital of $15,000. During the first month of the business, following transactions took place:

  • On 3 July, the Company paid $5,000 security deposit to the landlord for the office which was acquired on rent. Monthly rent of $2,500 was agreed which will be paid at the end of each month.
  • On 5 July, the Company purchased some office equipment such as laptop, printers etc. by paying $4,000. Useful life of this equipment is estimated to be 3 years.
  • On 15 July, the Company purchased some supplies worth $6,000 required for completing a project. Half of this amount was paid in cash whereas half was agreed to be paid after 30 days.
  • On 20 July, the Company obtained an interest free loan of $15,000 from a related party to manage its working capital.
  • On 27 July, the Company successfully completed its first project worth $16,000. It was agreed that 25% of the amount will be paid by the customer at the time of completion of project whereas the remainder amount will be paid after 60 days.
  • On 31 July, the Company paid monthly rent of $2,500 and paid salaries to its employees amounting to $4,500.

In this chapter, we will not consider the transactions which are in italic and bold text as they have an impact on the income statement accounts as well. But don’t worry! we’ll check their impact on the accounting equation in our next chapter expanded accounting equation.

We’ll record the journal entry of each transaction and then check its impact on the accounting equation.

Date Accounts Debit Credit
1 July Cash 15,000  
  Owner’s equity   15,000
  (Recording initial capital)    

Date Accounts Debit Credit
3 July Security deposit 5,000  
  Cash   5,000
  (Recording refundable security deposit receivable)    

Date Accounts Debit Credit
5 July Office equipment 4,000  
  Cash   4,000
  (Recording the purchase of fixed assets)    

Date Accounts Debit Credit
20 July Cash 15,000  
  Loan payable   15,000
  (Recording the receipt of interest free loan)    

Four transactions have been recorded and you can see that after recording each transaction, the accounting equation is in balance. In the next chapter, we’ll learn the expanded accounting equation and see how the income statement accounts are related to this accounting equation.