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Introduction
The accounting equation is a mathematical expression that shows the relationship among the different elements of accounting, i.e. assets, liabilities, and capital (or "equity").
In a Nutshell
The basic accounting equation is:
Assets = Liabilities + Capital
Because of the two-fold effect of transactions, the equation always stays in balance.
To help you better understand how the accounting equation works and stays in balance, we'll illustrate sample transactions and show how they affect the accounting equation.
Sample Business Transactions
Below are additional transactions following example 1, 2 and 3 in the previous lesson:
- Rendered services and received the full amount in cash, $500
- Rendered services on account, i.e., receivable from customer, $750
- Purchased office supplies on account, i.e., payable to supplier, $200
- Had some equipment repaired for $400, to be paid after 15 days
- Mr. Alex, the owner, withdrew $5,000 cash for personal use
- Paid one-third of the loan obtained in transaction #2
- Received customer payment from services in transaction #5
Let's take a look at how each transaction affects the accounting equation:
| 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) |
= |
|
+ |
|
| 4. Service revenue for cash |
500.00 |
= |
|
+ |
500.00 |
| 5. Service revenue on account |
750.00 |
= |
|
+ |
750.00 |
| 6. Supplies on account |
200.00 |
= |
200.00 |
+ |
|
| 7. Repair of equipment |
|
= |
400.00 |
+ |
(400.00) |
| 8. Owner's withdrawal |
(5,000.00) |
= |
|
+ |
(5,000.00) |
| 9. Payment of loan |
(10,000.00) |
= |
(10,000.00) |
+ |
|
| 10. Collection of accounts |
750.00
(750.00) |
= |
|
+ |
|
| Balance |
36,450.00 |
= |
20,600.00 |
+ |
15,850.00 |
Examples Explained
- The company received cash for services rendered. Cash increased thereby increasing assets. At the same time, capital is increased as a result of the income (Service Revenue). As we've mentioned in the Accounting Elements lesson, income increases capital.
- The company rendered services on account. The services have been rendered, hence, already earned. Thus, the $750 worth of services rendered is considered income even if the amount has not yet been collected. Since the amount is still to be collected, it is recorded as Accounts Receivable, an asset account.
- Office supplies worth $200 were acquired. This increases the company's Office Supplies, part of the company's assets. The purchase results in an obligation to pay the supplier; thus a $200 increase in liability (Accounts Payable).
- The company incurred in $400 Repairs Expense. Expenses decrease capital. The amount has not yet been paid. Thus, it results in an increase in total liabilities.
- The owner withdrew $5,000 cash. Cash is decreased thereby decreasing total assets. Withdrawals or drawings decrease capital.
- One-third of the $30,000 loan was paid. Therefore, Cash is decreased by $10,000 as a result of the payment. And, liabilities are decreased because part of the obligation has been settled.
- The $750 account in a previous transaction has been collected. Therefore, the Accounts Receivable account is decreased and Cash is increased.
Notice that every transaction results in an equal effect to assets and liabilities plus capital. The beginning balances are equal. The changes arising from the transactions are equal. Therefore, the ending balances would still be equal.
The balance of the total assets after considering all of the above transactions amounts to $36,450. It is equal to the combined balance of total liabilities of $20,600 and capital of $15,850 (a total of $36,450).
Assets = Liabilities + Capital is a mathematical equation. Using simple transposition, the formula can be rewritten to get other versions of the equation.
- Liabilities = Assets - Capital
- Capital = Assets - Liabilities
