There is a basic accounting equation which relates to the double-entry system. The equation will always balance unless a mistake has been made.
Assets = Liabilities + Equity (Owners or Shareholder funds)
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.
Basic Accounting Equation Example
Below is a simple Balance sheet showing Assets, Liabilities and Equity; from this, we can use the equation.
|Fixtures and Fittings||750|
From the simple example above the equation now looks like this:
Assets 3000 = Liabilities 500 plus Equity 2500
Therefore 3000 = 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 2500 = 2500
Basic Accounting Equation Explained
We have looked at what the equation is, and now we will look at the detail behind the figures. It is a basic list, but a larger business may have more categories.
These are items that the company owns and includes the following:
- Fixed Assets – Computers, fixtures and fittings, equipment and land
- Current Assets – Bank, stock and accounts receivable
- Tangible Assets – Goodwill, trademarks and patients
- Accounts payable – payments owed to suppliers
- Bank loans and overdraft
- Paye and wages owed
- Capital invested
- Retained earnings – Net income from the profit and loss account
Double Entry Accounting
As with all accounting, as it is a double entry, 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.
Return from free basic accounting equation to Accounting Basics page.