THE ACCOUNTING EQUATION —ASSETS= LIABILITIES+ EQUITIES

The accounting equation shows the relationship between the assets, liabilities, and owner's equities of a business entity. 

It states that, at all times and without exceptions,  the assets of a business entity are financed through debt or owner contribution.

The accounting equation is the basis of the double-entry system (a system that asserts that debit entry should have a corresponding credit entry).

It assumes that the asset of a business is equal to its liability and owner's equity. 

Mathematically, The accounting equation is represented as follows; Asset=liabilities+owner's equity

Just like any equation, this equation can be re-order this way:

Owner's equity= Asset-liabilities

OBSERVATIONS FROM ACCOUNTING EQUATION

1. The owner's equity is asset minus liability.

2. What the business owns (Assets) is equal to what it owes (liabilities and owner's equity)

Let's test our knowledge on this.

If the business owed its creditor €15,000 and its owner equity is €20,000, calculate its asset?

Recalled that asset=liability+owner's equity

Asset=€15,000+€20,000

         =€35,000

Assets, liabilities, and capital are three widely used accounting elements, hence, we must take a closer look at each one of them.

Assets

These are economic resources or tools owned or controlled by a business entity that is expected to provide future benefits or easily converted to cash. 

Take note of the word "owned or controlled". Some assets are controlled by a business but not technically owned by them. Examples of such assets are non-cancelable leased equipment.

Asset

A more formal definition is that "an asset is an economic resource controlled by a business as a result of past transaction or event which is expected to provide future economic benefits."

Among the better-known assets are buildings, warehouses, lorries, computer equipment(including input devices), furniture.

Let's briefly look at some assets:

  • Trade receivable: Amount due from customers for goods that have already been delivered.
  • Inventory: Stocked goods that are available for sale.
  • Property, plant, and equipment: A general name for non-current assets like computer equipment, vehicles, machinery, and furniture which are not used up within an accounting period.

Assets may be bifurcated into current and non-current assets:

*Current assets- These are assets that are used up within an accounting period, usually twelve months. There are easily converted to cash. 

A typical business usually has the following current asset: Inventory, trade receivable, rent receivable, interest receivable, bill receivable, prepaid expenses, cash at hand, cash at bank, short-term investment, prepaid VAT(value-added tax)

*Non-current assets- These exist for more than an accounting period(12 months). They are tools owned by a business that is used for its continuous production. 

Among the better known non-current asset are equipment, land and building, furniture and fitting, long-term investment, copyright, goodwill.

  7 users of financial information explained

Company assets come from two sources: borrowing from a third party(liabilities) and owner contribution(Capital).

Liabilities

These are third-party claims on the business. They are economic debts or obligations that a business owes to other people that are not owners of the business. 

The definition given above is somewhat simplified.

A formal definition is that "liability is a present obligation or debt of an entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits".

Like assets, liabilities can be bifurcated into non-current and current liabilities. *Current liabilities– These are debts or obligations that are expected to settle within an accounting period. Examples are bank overdraft, trade payable, accrued expenses, short-term loan, tax payable, rent payable, unearned revenue (or revenue in advance), outstanding value-added tax(VAT).

A current liability can also be defined as debt or obligation which is expected to be settled from existing current assets or  through the creation of other current liabilities

*Non-current liabilities- These are debts that are not payable within an accounting period.  Examples are long-term loans, mortgage loans, bonds.

Owner's equity

The owner's equity is the owner's interest in the business. It is the resources that the business owes to its owner(s). It is the excess of the asset over liabilities. 

The term "owner equity" varies from one business to another. In partnership, it is called a partner's equity. In a corporation, it is called stockholder's equity. 

In any case, the owner's equity will always equal the difference of asset and liability

Owner equity is affected by the owner's initial contribution, withdrawal(drawings), and net profit.

Now, Let's test our knowledge with these two examples

Example 1

Compute the owner's equity If

Equipment: €3000

furniture: €500

Vat prepaid: €400

Bill payable: €300

Apprentice premium carried forward: €500

Bank overdraft: €200

Equipment, furniture, prepaid VAT are assets. on the other hand, bill payable, apprentice premium carried forward(unearned revenue), bank overdraft are liabilities.

Hence,

€3000+€500+€400=€300+€500+€200+owner's equity

€3900=€1000+owner's equity

€3900-€1000=owner's equity

€2900= owner's equity

Owner's equity=€ 2900

Example 2

Analyze its affect on the accounting equation Assuming that the following transaction

  1. Mr Daniel brought in cash of €200,000 into the business 

  2. The company purchased equipment worth €10,000

  3. The company obtained a bank loan of €3,000.

  4. The company received €10,000 in the ad "  Vance for services it will render next year

AssetsLiabilitiesOwner's equity
€200,000=_______+€200,000
€10,000(€10,000)=_______+________
€3,000=€3,000+________
€10,000=€10,000+________
€213,000=€13,000+€200,000

Explained

  1. The cash(asset) of the business will increase, the capital of the business will also increase. This transaction does not affect liabilities, hence, it stays at Zero

  2. This transaction will affect the cash and equipment of the business. This transaction affects only the assets side of the accounting equation. Cash will decrease since it is used to buy equipment. Equipment will in turn increase.

  3. This affects the asset and liabilities of the business. Cash(asset) is increasing just like bank loan(liability) is also increasing.

  4. This might confuse those that are new to accounting. The two accounts affected are cash and unearned revenue. Remember that unearned revenue is cash that the business received for goods or services that it has not supplied or rendered. The asset will increase, liabilities will increase.

At the underside of the table, you can see that the balance of the asset(€213,000) is equal to the balance of both liability and capital(€200,000+ €13,000).

Related post

From the aforementioned example, you will observe that the beginning balances are equal. The changes after each transaction are equal. The final balance is also equal. 

This reflects that, for every transaction, the assets will always equal the sum of liabilities and capital.

Want more examples? See my blog post on journal entries here

As usual, if you have questions, contributions, feel free to tell me in the comment box. 

Which of the following transactions would reduce asset and reduce liability?

Sale of goods on credit
Cash received from trade receivable
Purchases of goods on credit
Cash paid to trade payables

see explanation

When cash is paid to creditors(trade payables), the amount of cash(an asset) the business reduces while the amount owed to creditors( a liability) reduces.

Hence, assets and liability decrease.

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