What is the accounting equation?

The accounting equation indicates the relationship between the assets, liabilities, and shareholders’ equity (owners’ equity) of a business.

The equation is a basic principle of accounting, a simplified classification of the values of a business’s key components reported on the balance sheet, also referred to as the statement of financial position.

The accounting equation, also referred to as the balance sheet equation or the basic or fundamental accounting equation, is regarded as the basis of the double-entry accounting system (refer below).

Formula for the accounting equation

The basic formula for the accounting equation is Assets = Liabilities + Owners’ equity. The equation must always be kept in balance.

The implication of the basic formula is that every asset acquired by a business was financed either through a liability or capital invested by the owners of a business.

Owners’ equity, the term usually used when the business is a sole proprietorship, is also called shareholders’ equity or stockholders’ equity when the entity is a company.

The accounting equation can also be expressed in the following ways:

Owners’ equity = Assets – Liabilities, or

Liabilities = Assets – Owners’ equity.

Categories of the accounting equation

As mentioned, the accounting equation includes three categories:

• Assets

Assets refer to items or resources a business owns. All assets owned by a business are acquired with the money supplied either by creditors, financial institutions, or the owner(s).

• Liabilities

Liabilities, also referred to as obligations, refer to the money a business owes to creditors (suppliers) and lenders. Liabilities are claims against the business’s assets and have preference over the claims of owners.

• Owners’ equity

Owners’ equity represents the amount of money invested in a company by the owners (shareholders) plus the cumulative net income of the company that is available for the distribution of dividends or for future company operations.

Put differently, it refers to the value of an asset minus the liabilities related to that specific asset, representing claims of owners against the company.

The double-entry accounting system

The double-entry system is consequential to the accounting equation, being a fundamental concept in present-day accounting and bookkeeping, implying that every financial transaction has equal and opposite outcomes in at least two different accounts in the business’s ledger accounts.

Typically, ledger accounts are classified into seven different types of accounts in which the debits and credits of financial transactions are recorded, namely:

• Assets
• Liabilities
• Owners’/shareholders’ equity
• Revenue
• Expenses
• Gains (profits)
• Losses

Debits and credits

In the double-entry system, financial transactions are recorded as debits and credits in different ledger accounts. A debit or the sum of all debits must equal a credit or the sum of all credits.

In accounting, debits are transactions that are recorded on the left side of an account ledger, while credits reflect entries on the right side of an account ledger.

Debits do not per se increase the balances of ledger accounts, neither do credits always decrease the balances of ledger accounts. For example:

Accounts increased by debits	Accounts decreased by debits
Assets	Liabilities
Expenses	Equity accounts
Loss accounts	Revenues
	Profit (gains) accounts

Accounts increased by credits	Accounts decreased by credits
Liabilities	Assets
Revenues	Expenses
Equity accounts	Loss accounts
Profit (gains) accounts

Example 1

• Firm Easy Going purchases office furniture (R50 000) and stationery (R5 500) from one supplier. Before the purchase, Easy Going’s assets totalled R750 000, its liabilities amounted to R250 000 and its owners’ equity reflected R500 000. The transaction will be reported as follows:

Debit stationery (expense account) with R5 500. This entry will reduce the profit of the firm by R5 500, eventually affecting owners’ equity.

Debit office furniture (asset account) with R50 000.

Credit the cash account (asset account) with R55 500.

The transaction will affect the accounting equation, assets = Liabilities + Owners’ equity

as follows:

• Before the transaction: R750 000 (assets) = R250 000 (liabilities)+ R500 000 (owners’ equity) (sum of liabilities and owners’ equity = R750 000).
• After the transaction: R744 500 (R750 000 + R50 000 – R55 500) (assets) = R250 000 (liabilities) + R494 500 (R500 000 – R5 500) (owners’ equity) (sum of liabilities and owners’ equity = R744 500).

Example 2

• Company Well Away buys material to manufacture goods on credit terms of 30 days for R50 000 from a supplier. The company has, inter alia, the following balances in its accounts: Assets – R300 000, liabilities – R170 000, and owners’ equity – R130 000.

The transaction will be recorded as follows:

Debit inventory (asset account) with R50 000.

Credit accounts payable (liability account) with R50 000.

The transaction will change the accounting equation as follows:

• Before the transaction: R300 000 (assets) = R170 000 (liabilities) + R130 000 (owners’ equity) (sum of liabilities and owners’ equity = R300 000).
• After the transaction: R350 000 (R300 000 + R50 000) (assets) = R220 000 (R170 000 + R50 000) (liabilities) + R130 000 (owners’ equity) (sum of liabilities and owners’ equity = R350 000).

Example 3

• When company Well Away pays the supplier after 30 days, the following transaction will be recorded in the company’s accounting system:

Debit accounts payable (liability account) with R50 000.

Credit the cash account (asset account) with R50 000.

The effect of the transaction on the accounting equation will be as follows:

• Before the transaction: R350 000 (assets) = R220 000 (liabilities) + R130 000 (owners’ equity) (sum of liabilities and owners’ equity = R350 000).
• After the transaction: R300 000 (R350 000 – R50 000) (assets) = R170 000 (R220 000 – R50 000) (liabilities) + R130 000 (owners’ equity) (sum of liabilities and owners’ equity = R300 000).

It is noticeable that every double-entry concerning a financial transaction affects both sides of the accounting equation. For every change to an asset account, there must be a change to a related liability or owners’ (shareholders’) equity account that equals the change regarding the particular asset account.