What is an Accounting Equation?

The accounting equation, also known as the balance sheet equation, is a fundamental principle in accounting that represents the relationship between a company’s assets, liabilities, and owner’s equity.

The basic accounting equation is expressed as:

Assets=Liabilities+Owner’s Equity

This equation is the foundation of the double entry accounting, ensuring that for every transaction, the total debits equal the total credits.

It is used to prepare a financial statement and determine company profitability and worth.

The equation is essential for maintaining balanced financial records and is a key concept in accounting practice.

Assets

Assets are the valuable resources controlled by a company, such as property, inventory, equipment, patents, trademarks, copyrights, accounts receivable, and reputation.

An asset is also something a company can sell.

Liabilities

Liabilities represent a company’s debts or financially-measurable obligations, including current and long-term liabilities.

Current liabilities are obligations that the company should settle within one year, while long-term liabilities are obligations due in more than one year.

Owners Equity or Shareholders Equity

Equity refers to the ownership interest in a company, which can be represented as shareholders’ equity, stockholders’ equity, or owner’s equity.

Equity is the difference between total assets and total liabilities.

Equity also usually includes Capital, Retained Earning, and dividends.

Expanded Accounting Equation/Form/ Formula

The expanded accounting equation breaks down the components of owner’s equity further, providing a more detailed view.

The expanded form is:

Assets=Liabilities+Owner’s Capital+Revenues−Expenses−Drawings

The expanded accounting equation is a useful tool for understanding how various financial elements interact within a business.

Cash Flow

The effects of cash flow in the financial accounting (equation) is usually an increase in Assets and Equity or Assets and Liabilities.

Net Income/Calculator

The accounting equation for net income is derived using the expanded form.

Here is the calulation of net Income accounting equation:

Net Income = Assets+Drawings-Liabilities-Owner’s Capital 

Here how it is derived:

Assets=Liabilities+Owner’s Capital+Revenues−Expenses−Drawings
Assets=Liabilities+Owner’s Capital+Net Income−Drawings
Assets+Drawings=Liabilities+Owner’s Capital+Net Income

Cheat Sheet/Examples

An accounting equation cheat sheet typically refers to a quick reference guide that summarizes the accounting equation and its components.

Here’s a simple cheat sheet for the accounting equation:

accounting equation cheat sheet

Accounting Equation for Balance Sheet (Financial Statement)

The accounting equation is a fundamental principle in accounting and serves as the foundation for the balance sheet.

The equation is:

Assets=Liabilities+Owner’s Equity

This equation must always be in balance, meaning that the total assets of a business must be equal to the sum of its liabilities and owner’s equity.

Equation for Liabilities

In the context of liabilities, the equation can be rearranged to solve for liabilities:

Liabilities=Assets−Equity

This equation illustrates that a company’s liabilities are equal to its assets minus its equity.

Liabilities represent the claims creditors have on the company’s assets, and they include obligations such as loans, accounts payable, and other debts.

Normal Balances

Regarding normal balances, it refers to the usual balance (debit or credit) that an account carries.

In double-entry accounting, each transaction affects at least two accounts, and each account has a normal balance, either a debit or a credit.

Here’s a table summarizing the normal balances for accounting equation:

Account TypeNormal BalanceIncrease Recorded AsDecrease Recorded As
AssetsDebitDebitCredit
LiabilitiesCreditCreditDebit
EquityCreditCreditDebit

Equity Equation

The accounting equation for equity can be expressed as:

Equity=Contributed Capital+Retained Earnings

Equity is the residual interest in the assets of the entity after deducting liabilities. It represents the ownership interest of the owners (shareholders) in the business.

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