The Accounting Equation and How It Stays in Balance

The accounting equation is the unifying concept in accounting that shows the relationships between and among the accounting elements: assets, liabilities, and capital.

In this lesson (and the next ones), you will learn about the basic accounting equation and how it stays in balance.

Before taking this lesson, be sure to be familiar with the accounting elements.

Basic Accounting Equation

When a business starts to operate, its resources (assets) come from two sources: contributions by owners and resources acquired from creditors or lenders. In other words, all assets initially come from liabilities obtained and owners' contributions. This is the idea of the accounting equation.

The basic accounting equation is:

Assets = Liabilities + Capital

As business transactions take place, the values of the accounting elements change. The accounting equation nonetheless always stays in balance.

Every transaction has a two-fold effect. Meaning, at least two accounts are affected. Let's illustrate all of that through these examples.

Assume the following transactions:

  1. Mr. Alex invested $20,000 to start a printing business,
  2. The company obtained a loan from a bank, $30,000,
  3. The company purchased printers and paid a total of $1,000.

How will the transactions affect the accounting equation?

Let us take a look at transaction #1:

Transaction Assets = Liabilities + Capital
1. Owner's investment 20,000.00 = - + 20,000.00

Again, every transaction has a two-fold effect. In the above transaction, assets increased as a result of the increase in Cash. At the same time, Capital increased due to the owner's contribution. Remember that capital is increased by contribution of owners and income, and decreased by withdrawals and expenses. No liability is affected hence, stays at zero.

Let's continue with transaction #2:

Transaction Assets = Liabilities + Capital
1. Owner's investment 20,000.00 = - + 20,000.00
2. Loan from bank 30,000.00 = 30,000.00 + -

In transaction #2, the company received cash. Thus, the value of total assets is increased. At the same time, it incurred in an obligation to pay the bank. Therefore, liabilities are increased. The liability in this case is recorded as Loans Payable.

Notice also that the accounting equation is still equal (balanced).

Let's add transaction #3:

Transaction Assets = Liabilities + Capital
1. Owner's investment 20,000.00 = - + 20,000.00
2. Loan from bank 30,000.00 = 30,000.00 + -
3. Purchased printers 1,000.00
(1,000.00)
= - + -

The company acquired printers, hence, an increase in assets. However, the company used cash to pay for the printers. Thus, it also results in a decrease in assets. Transaction #3 results in an increase in one asset (Service Equipment) and a decrease in another asset (Cash).

For those who are new to accounting format: The parentheses "()" around the 1,000 amount above means minus or "less".

Liabilities and capital are not affected. Still, the equation in the third transaction is equal. In this case, it has zero effect on both sides.

At this point, the balance of total assets is $50,000. The combined balance of liabilities and capital is also at $50,000.

The accounting equation is (and should always be) in balance.

Accounting Equation: More Examples

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