What is the Accounting Equation?

A close second to discovering America in the 1400’s is the creation of the accounting equation by Luca Pacioli in 1494. This mathematician created a formula that has stood the test of time. Whether big or small, virtually every organization throughout the world uses the accounting equation as the foundation for every transaction.

What is the accounting equation?

The accounting equation is the formula:

Assets = Liabilities + Owner’s Equity

This formula expresses the relationship between what an organization OWNS and what the organization OWES. The owner’s equity is the portion left over.

Assets

Assets represent everything the company owns or has claim too. It includes: cash, accounts receivable, inventory, prepaid expenses, fixed assets, long term receivables among other items.

Liabilities

Liabilities represent everything the company owes to a third party. It includes accounts payable, customer deposits, debt, deferred revenue and more.

Owner’s equity

Owners equity represents the claim owners or shareholders have on the remaining assets of the company. Or simply put, it is the value left after assets have paid all the liabilities.

How does the accounting equation work?

The accounting equation works because of double entry accounting.

Double entry accounting means there is a debit and a credit for every transaction.

The double entry keeps the accounting equation in balance by increasing one component and decreasing another component of the formula.

A debit increases assets and expenses, and decreases liabilities, revenue and owner’s equity.

A credit, increases liabilities, revenue and owner’s equity, and decreases assets and expenses.

EXAMPLE: If you pay a bill, assets will decrease and expenses will increase.

You might be asking yourself how does expense fit into the accounting formula? Let’s explain.

How is owner’s equity calculated?

Assets and liabilities are easy to understand but owner’s equity is a little more involved. Owner’s equity includes owner’s contributions and owner withdrawals. Contributions increase equity and withdrawals decrease equity.

The other part of the owner's equity is revenue and expenses. The net of these two categories is moved from the income statement to the owner’s equity account. If we expand the formula to include revenue and expense it would look like this:

Assets = Liabilities + [Capital – Distributions + Revenue – Expense]

Capital

Capital represents any investments made by an owner or shareholder.

Distributions

Distributions represents any money distributed to owners or shareholders in terms of dividends or owner draws.

Revenue

Revenues represents company sales, interest income, rental income, service fees and other revenue generating activities.

Expense

Expenses represent anything the company pays like cost of goods sold, payroll, advertising, utilities, professional fees, rent and much more. Expenses may even include noncash expenses such as depreciation.

EXAMPLE: If the income statement shows revenue of $100,000 and expenses of $92,000 the net income or profit is $8,000. This $8,000 is reflected in the owner’s equity account as earnings.

To summarize, owner’s equity includes contributions, distributions and net income.

The accounting equation rearranged and explained

The accounting equation is a very simple algebraic formula that can be rearranged in various formats to solve for any single component, but more than that expressing it in a different format answers different questions.

Format #1

Assets = Liabilities + Owners Equity

This answers the question: What is the financial position or condition of the company? It is the arrangement you will find on the balance sheet. Notice in the example below the Asset balance of $472,100 equals the combined balance of $472,100 for the liabilities and owner’s equity.

Format #2

Owner’s Equity = Assets - Liabilities

This answers the question: How much is left after all creditors of an organization have been paid? Creditors have first claim on all the assets followed by owner’s and stockholders.

Format #3

Assets = Liabilities + Capital + Revenue - Expenses

This answers the question: What is the relationship between owner’s equity and the income statement? By expanding owner’s equity into subgroups, you can see the relationship between the income statement and the balance or owner’s equity.

Format #4

Net Assets = Assets - Liabilities

This answers the question: What are the net assets of an organization? This is similar to format #1 but Owner’s Equity is stated as Net Assets. Net Worth, Net Assets, Owner's Equity are essentially all the same thing described in a different way. It might also be called Book Value as it defines how much the assets of an organization are worth after all liabilities have been settled. However, understanding book value and market value are not the same value.

Does the accounting equation apply to the balance sheet or income statement?

The accounting equation affects both the balance sheet and the income statement; however, assets, liabilities and owner’s equity are only found on the balance sheet. As implied in the discussion of owner’s equity, the net income from the income statement posts to owner’s equity thus linking the balance sheet and the income statement together.

The balance sheet is one of the primary statements used in accounting. Its purpose is to document the financial condition of a company at a point in time. It highlights what the company owns (Assets), what the company owes (Liabilities), and the effectiveness of the operation over time (Equity).

The balance sheet will help management or a third party understand the following:

1. What is owned.
2. What is owed.
3. Ability to pay current obligations.
4. Liquidity
5. Financial results of current year.
6. Combined financial results of previous years.
7. Use of profits: reinvested or distributed.

In essence the balance sheet is the most important statement revealing the financial condition of a company.

Example of the accounting equation

To this point you have learned the accounting equation is assets = liabilities + owners’ equity with owner’s equity divided into capital, revenue and expenses. In addition, every transaction in accounting must follow the double entry method of including a debit and a credit. Further, each debit/credit will affect one or many components in the equation. All of this ensures the formula remains in balance.

Here are a few examples:

1.  XYZ company paid their utility bill of $200.

Utility Expense $200

Cash $200

(increases expense with a debit, and decreases assets with a credit)

2. XYZ company collects payment of $1000 from a customer who purchased on terms.

Cash $1,000

Accounts Receivable $1,000

(increases assets with a debit, and decreases assets with a credit)

3. XYZ company received a contribution from its owners of $5,000.

Cash $5,000

Owners’ Equity $5,000

(increases assets with a debit, and increases owner’s equity with a credit)

4. XYZ company sold $10,000 worth of widget A to a customer on 30-day terms.

Accounts Receivable $10,000

Sales 10,000

(increases an asset with a debit, and increases revenue with a credit)

5. XYZ company paid $5000 in wages for the current period.

Payroll Expense $5,000
Cash $5,000

(increases expense with a debit, and decreases assets with a credit)

You will not from all of these examples there is always a debit and a credit. If one side of the equation increases, the other side of the equation increases. The only real tricky one is expense. Notice in #5 above, payroll expense which is on the right side of equation increased, but cash which is on the left side of the equation decreased. That would seem to bring unbalance to the accounting equation. However, as you look closer, you realize that expense actually reduces owner’ equity thus keeping the accounting equation in balance.