What is the Accounting Equation and How Does It Work

What is an accounting equation? This is the relationship expressed between the three basic accounting elements in the balance sheet or statement of financial position i.e., assets, liabilities and equity. All accounting or financial information is recorded within the framework of the accounting equation.

The following are the parts of the Accounting Equation as shown in the balance sheet (statement of financial position:

Assets – are the resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. This includes cash, receivables, inventories, prepayments, investments, property and equipment.

Liabilities – are the present obligations of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. This includes accounts payable, accrued expenses, income tax payable, unearned revenue and loans payable.

Equity – this is the owner/s’ interest on the assets of the enterprise after deducting all its liabilities. The structure of equity depends on the form of a business: sole proprietorship (owner’s equity), partnership (partners’ equity), stock corporation (stockholders’ equity), and nonstick – nonprofit corporation (fund balances or members’ equity).

The following are the accounting equation for the different forms of business or enterprise:

For sole proprietorships:
Assets = Liabilities + Owner’s Equity

For partnerships:
Assets = Liabilities + Partners’ Equity

For stock corporations:
Assets = Liabilities + Stockholders’ Equity

For non-stock, non-profit corporations:
Assets = Liabilities + Fund balances

Because of the double-entry accounting, this equation should always be in balance. The amount on the left side of the equation should always equal to the amount on the right side of the equation. If assets increase, liabilities and/or equity must increase by the same amount. If assets decrease, liabilities and/or equity must also decrease. An increase in an asset may also have a corresponding decrease in another asset account or an increase in liability may also have a corresponding decrease in another liability account.

To further understand the accounting equation, let’s take the following example:

Assets =	Liabilities +	Owner’s Equity
Cash: P10,000	Accounts payable: P7,000	Capital: P30,000
Accounts Receivable: P20,000	Accrued expenses: P3,000	Drawings: (P15,000)
Supplies: P10,500	Bank loans: P6,000	Revenues: P50,000
Equipment: P20,500	Income tax payable: P4,000	Expenses: (P24,000)
Total Assets: P61,000	Total Liabilities: P20,000	Total Equity: P41,000

 

As we can see, the total assets (P61,000) is equal to the total liabilities and equity (P20,000+41,000=P61,000). The assets should always be balance with the sum of liabilities and equity. If an asset increases by P5,000, there must also be a total amount of P5,000 increase in liabilities and/or equity, or a total amount of P5,000 decrease in another asset account. The accounting equation expresses the balance sheet. That is why it is called the balance sheet because the total amount of assets should always be balance to the total amount of liabilities and equity.

Stay tuned for our next accounting discussion, which we will tackle how to make journal entries and record business transactions in the General Journal.