December 6, 2021

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The Accounting Equation: Meaning, Formula

The Accounting Equation: Meaning, Formula
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One fundamental aspect of accounting is the equation. Aside from the double-entry principles, this equation is one basic principle you need to understand in financial accounting. Although, it covers assets, liabilities, and capital. In some ways, it is required to understand income and expenses as well. Let’s dive in!

Meaning of Accounting Equation

The accounting equation is simply Assets less capital and liabilities. It can be defined as a formula that equates the three aspects of a balance sheet (statement of financial position).

Key Explanations

Assets: These are the properties of a business. Examples are cash, bank account, investments, stocks of goods (inventories), account receivables, plants and machinery, land and building, equipment, just to name a few.

Liabilities: Debts a business must pay people who are not part of the organization. Creditors, account payables, bank overdrafts, loans from a bank, bonds, and debentures fall under this category.

Capital: Also called owners equity or simply “equity.” The total amount of money contributed by the owners/shareholders of the business. It is affected by the contribution of the owners, the amount withdrawn by the business, and profit or loss.

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Income and expenses affect profit. An increase in income or decrease in expense means an increase in profit, therefore a capital increase. However, an increase in expenses or a decrease in income means less profit, therefore lower capital.

Balance Sheet: That is, the statement of financial position. It is in this statement the accounting equation is applied. Assets and liabilities are classified as current and noncurrent. While equity is a standalone item. The balance sheet tells us where the business stands base on historical costs and modified market costs.

The Accounting Equation Formula

The formula for the accounting equation is simple Assets = Capital + Liabilities. This formula can be modified in two ways. Liabilities = Assets – Capital and Capital = Assets – Liabilities.

What the equations are saying is simple. In financing a business, you need two things: capital and liabilities. With this, you can buy the assets required to run and manage the business. It also means that you can use capital only to finance a business. This gives Assets = Capital. Furthermore, if liabilities are unknown, you can find them by subtracting capital from assets. And when capital is unknown, we find it by subtracting liabilities from assets.

Assets = Capital
Assets = Capital + Liabilities
Capital = Assets – Liabilities
Liabilities = Assets – Capital

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Conclusion

The accounting equation has been defined. Also, the formula was provided. The equation is meant to show how a balance sheet works. While the equation doesn’t include income and expenses, these can affect capital.

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