Basic Accounting Equation

The Basic Accounting Equation is a simple equation that states that the total value of a company’s assets must be equal to the total value of its total liabilities and shareholder equity.

This accounting equation is used to track the financial health of a company by ensuring that its assets always equal its liabilities plus its equity. The Basic Accounting Equation is also known as the balance sheet equation.

The Basic Accounting Equation and the Double Entry Bookkeeping System

The Basic Accounting Equation should always balance due to double entry accounting. This means that every time a company records an entry in its accounting books, it must also record a corresponding entry in another account. This ensures that the total value of a company’s assets always equals the total value of its liabilities and shareholder equity.

What is the Basic Accounting Equation and What Does it Mean for a Company’s Financial Health

The Basic Accounting Equation is a fundamental principle of accounting that states that the total value of a company’s assets must be equal to the total value of its liabilities and shareholder equity. This equation is used to track a company’s financial health and ensure that its assets are not being overspent.

Accounting ratios are used to measure of a company’s performance and finacial health. There are many different accounting ratios, but some of the most commonly used ones are the debt to equity ratio, the current ratio, and the return on equity.

The Basic Accounting Equation is written as:

Assets = Liabilities + Equity (Owners or Shareholder funds)

There are three components to the Basic Accounting Equation: assets, liabilities, and shareholder equity

In more detail, an asset is something that you own; this includes computers, equipment, premises, goodwill, patents, money, and accounts receivable.

Liabilities is money that you owe and includes loans, accounts payable, overdrafts and taxes payable.

Equity is the amount that owners have introduced into the business and any profit and loss (retained earnings).

Basic Accounting Equation Example

Below is a simple Balance sheet showing Assets, Liabilities and Equity; from this, we can use the equation.

From the simple example above, the equation now looks like this:

Assets 3000 = Liabilities 500 plus Equity 2500

Therefore both sides equal 3000

The retained earnings are the figures from the profit and loss account.

As with all equations, you can rearrange the accounting equation. Rearranging, it would give the following:

If we go back to our example above, the equation will now look like this:

Equity 2500 = Assets 3000 – Liabilities 500

Therefore both sides equal 2500

Basic Accounting Equation Explained

The Basic Accounting Equation is a simple equation that states that the assets of a business are equal to the liabilities plus the equity. This equation is important because it helps to understand how a business functions and how it earns money.

We will now look in detail at each section of the equation with a brief description:

Assets

These are items that the company owns and includes the following: 

Fixed Assets

Fixed Assets are long-term assets that a company owns and uses in the production of its goods or services. These assets usually have a life span of more than one year and include things such as land, buildings, equipment, and patents.

Current Assets

Current assets are assets that a company can turn into cash within one year. This includes things such as cash, accounts receivable, and inventory.

Intangible Assets

Intangible assets are items that a business owns that are not physical and include goodwill, trademarks and patients.

Liabilities

A liability is a financial obligation of a company. It is recorded on the company’s balance sheet as a debt. Liabilities are divided into two categories: current and long-term.

Current Liabilities

Current liabilities are those that must be paid within one year and include the following:

• Accounts payable – payments owed to suppliers
• Bank loans and overdraft
• Paye and wages owed
• Accruals

Long-Term Liabilities

A long-term liability is a debt that must be paid back over a period longer than one year. The most common types of long-term liabilities are bonds and mortgages.

Owner’s Equity

Owner’s equity is the portion of a company’s balance sheet that represents the amount of money invested in the company by its owners. It is called owner’s equity because it is the equity (or ownership) of the owners in the company. It is made up of two components:

• Capital invested – Includes shareholder’s equity
• Retained earnings – Net income from the profit and loss account

As shown in the example below, all of the above transactions are recorded on the balance sheet, which is part of the financial statements.

Double Entry Accounting System

As with all accounting, as it is a double entry system, the basic accounting equation will always balance. Below are a few examples of how double entry adjusts the figures in the accounting equation.

A business purchases a computer – As both the bank and computer are both assets, the total figure of assets will not change.

A business pays for training – The assets will reduce as the money is taken from the bank, and the retained earnings will reduce as training is part of the profit and loss account.

A cost of sales item is purchased on credit – The accounts payable (liability) will increase, and the retained earnings will reduce.

Further reading is available on the balance sheet and double entry bookkeeping pages.

Conclusion on the Basic Accounting Equation

The basic accounting equation is a fundamental principle of double-entry bookkeeping. The equation states that the total assets of a company must be equal to the total liabilities plus owner’s equity. This equation ensures that all transactions are accounted for and provides a snapshot of a company’s financial position at any given moment.

Return from free basic accounting equation to Accounting Basics page.