Accounting equation definition

What is the Accounting Equation? 

An equation that shows the relationship between Assets, Liabilities, and Owner's Equity is known as the accounting equation. The left side of the equal sign shows the assets and the right side of the equation shows the company's liabilities. Both sides should be balanced in this equation after recording a transaction.

Assets = Liabilities + Shareholders' Equity

Assets

The resources that are used to generate revenue from a business are assets. If assets are acquired then the left side of the accounting equation increases. Examples of assets include cash, accounts receivable, fixed assets, and inventory. Assets can be paid by incurring liabilities to a third party or by obtaining funds from investors. 

Liabilities

Liabilities are the amount that a business owes to a third party other than the owners of the business. These liabilities are third-party claims over the business. Some examples of liabilities are Accounts payable, Interest payable, Income taxes payable, Bank account overdrafts, Accrued expenses, Short-term loans or the current portion of long-term debt, etc.

Shareholders’ Equity

In a simple sense, Shareholders’ Equity is the money or resources the owners invested in the business. It's a claim of shareholders over the business. Shareholders’ Equity can be calculated from assets after subtracting the liabilities of the third party. The elaborated form of Owner's equity is (C+R-E-D).

Here, 

C = Capital (Increase Owner's Equity)

R = Revenue (Increase Owner's Equity)

E = Expenses (Decrease Owner's Equity)

D = Drawings (Decrease Owner's Equity)

Limitations of the Accounting Equation

The accounting equation is the framework of the balance sheet. It shows the underlying concept of creating a balance sheet. According to this equation, any transaction can be recorded perfectly even if the transaction is fraudulent.

Example of the Accounting Equation

Analyze the following transactions under the Accounting Equation Approach.

1. Started business with $200000 cash.
2. Purchased goods $25000
3. Paid salary $10000
4. Sold goods costing $20000 at a profit of 25% on the cost
5. Paid salary in advance $2000
6. Introduced additional capital of $10000
7. Purchased computer for $15000
8. Deposited $50000 into the bank 

Analyzing the transactions:

1. If the business started investing cash that will affect the owner's equity section and also affect the asset section. Both asset (cash) and owner's equity increase.
2. Purchasing goods will reduce the cash and also increase assets.
3. Paying salary will reduce cash (Assets) and also reduce the Owner's equity as an expense.
4. Goods sold $20000 so the stock will reduce by $20000. We will receive $25000 (25% of 20000) as cash, So the cash will increase. And we made a profit of $5000 so that will be added to the owner's equity.
5. Paying advance salary will create an asset as the labor owes the service to us now. So, it will increase Pre-paid Salary (assets), and also paying cash will decrease our cash balance. So, decrease in cash (assets).
6. Added to Cash and added to Owner's equity.
7. Decrease in cash, increase in the computer as an asset.
8. Cash decreases and bank balance increases.

You can download the solution.

Sheet Name :- Sheet1

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ASSETS							LIABILITIES + CAPITAL
	Cash	Stock	Computer	Pre-paid Salary	Bank	Total	Capital	Total
1	500000					500000	500000	500000
2	(25000) 475000	25000 25000				500000	500000	500000
3	(10000) 465000	25000				490000	(10000) 490000	490000
4	25000 490000	(20000) 5000				495000	5000     495000	495000
5	(2000) 488000	5000		2000  2000		495000	495000	495000
6	10000 498000	5000		2000		505000	505000	505000
7	(15000) 483000	5000	15000	2000		505000	505000	505000
8	(50000) 433000	5000	15000	2000	50000	505000	505000	505000

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