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Dur­ing the month of Feb­ru­ary, Metro Cor­por­a­tion earned a total of $50,000 in rev­en­ue from cli­ents who paid cash. The glob­al adher­ence to the double-entry account­ing sys­tem makes the account-keep­ing and ‑tal­ly­ing pro­cesses more stand­ard­ized and fool­proof. These are some simple examples, but even the most com­plic­ated trans­ac­tions can be recor­ded in a sim­il­ar way.

Impact of transactions on accounting equation

Wheth­er you call it the account­ing equa­tion, the account­ing for­mula, the bal­ance sheet equa­tion, the fun­da­ment­al account­ing equa­tion, or the basic account­ing equa­tion, they all mean the same thing. When the total assets of a busi­ness increase, then its total liab­il­it­ies or owner’s equity also increase. The account­ing equa­tion helps to assess wheth­er the busi­ness trans­ac­tions car­ried out by the com­pany are being accur­ately reflec­ted in its books and accounts. These ele­ments are basic­ally cap­it­al and retained earn­ings; how­ever, the expan­ded account­ing equa­tion is usu­ally broken down fur­ther by repla­cing the retained earn­ings part with its elements.

Notice that each trans­ac­tion changes the dol­lar value of at least one of the basic ele­ments of equa­tion (i.e., assets, liab­il­it­ies and owner’s equity) but the equa­tion as a whole does not lose its bal­ance. If the left side of the account­ing equa­tion (total assets) increases or decreases, the right side (liab­il­it­ies and equity) also changes in the same dir­ec­tion to bal­ance the equa­tion. The account­ing equa­tion equates a company’s assets to its liab­il­it­ies and equity. This shows all com­pany assets are acquired by either debt or equity fin­an­cing. For example, when a com­pany is star­ted, its assets are first pur­chased with either cash the com­pany received from loans or cash the com­pany received from investors. Thus, all of the company’s assets stem from either cred­it­ors or investors i.e. liab­il­it­ies and equity.

Single-entry vs. double-entry bookkeeping system

As we have seen in the example above, the $50,000 of cash which the own­er injects into busi­ness becomes the assets of $50,00. In this case, the deliv­ery equip­ment in account­ing total assets and owner’s equity increased $5,000 while total liab­il­it­ies are still the same. While the account­ing equa­tion goes hand-in-hand with the bal­ance sheet, it is also a fun­da­ment­al aspect of the double-entry account­ing sys­tem. The account­ing equa­tion is so fun­da­ment­al to account­ing that it’s often the first concept taught in entry-level courses.

Accounting Equation Concept

1. This busi­ness trans­ac­tion decreases assets by the $100,000 of cash dis­bursed, increases assets by the new $500,000 build­ing, and increases liab­il­it­ies by the new $400,000 mortgage.
2. Due to this, the owner’s equity is also known as net assets or net worth.
3. The account­ing meth­od under which rev­en­ues are recog­nized on the income state­ment when they are earned (rather than when the cash is received).

Cred­it­ors are owed $175,000, leav­ing $720,000 of stock­hold­ers’ equity. The bal­ance sheet is also known as the state­ment of fin­an­cial pos­i­tion and it reflects the account­ing equa­tion. The bal­ance sheet reports a company’s assets, liab­il­it­ies, and owner’s (or stock­hold­ers’) equity at a spe­cif­ic point michael finkel­stein author at the glob­al treas­urer 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.

This simple for­mula can also be expressed in three oth­er ways, which we’ll cov­er next. At first glance, this may look over­whelm­ing — but don’t worry because all three reveal the same inform­a­tion; it just depends on what kind of inform­a­tion you’re look­ing for. Metro issued a check to Office Lux for $300 pre­vi­ously pur­chased sup­plies on account. Debt is a liab­il­ity, wheth­er it is a long-term loan or a bill that is due to be paid. Shaun Con­rad is a Cer­ti­fied Pub­lic Account­ant and CPA exam expert with a pas­sion for teach­ing. After almost a dec­ade of exper­i­ence in pub­lic account­ing, he cre­ated MyAccountingCourse.com to help people learn account­ing & fin­ance, pass the CPA exam, and start their career.

Put anoth­er way, it is the amount that would remain if the com­pany liquid­ated all of its assets and paid off all of its debts. The remainder is the share­hold­ers’ equity, which would be returned to them. In oth­er words, the total amount of all assets will always equal the sum of liab­il­it­ies and share­hold­ers’ equity.

A liab­il­ity, in its simplest terms, is an amount of money owed to anoth­er per­son or organ­iz­a­tion. Said a dif­fer­ent way, liab­il­it­ies are cred­it­ors’ claims on com­pany assets because this is the amount of assets cred­it­ors would own if the com­pany liquid­ated. Now that we have a basic under­stand­ing of the equa­tion, let’s take a look at each account­ing equa­tion com­pon­ent start­ing with the assets. This long-form equa­tion is called the expan­ded account­ing equation.

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