Accounting Equation Notes TOPIC 3 THE ACCOUNTING EQUATION The Accounting Equation The

accounting equation

The balance sheet must be balanced, i.e. the level of assets must correspond to the level of liability. To illustrate this principle, let’s take the example of a company that makes a profit. It increases its level of assets, but also its level of liabilities since this profit becomes a debt of the company towards its partners (share capital). The total of the left-hand column of the balance sheet is equal to the total of the right-hand column.

Assets are the resources that the business owns, and from which the company is likely to benefit in the future. GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.

What is the Basic Accounting Equation and what does it mean for a company’s financial health

Total liabilities are all the costs you must pay to third parties, such as loan or interest payments. Current liabilities are the current debts the business has incurred. By subtracting revenue from expenses, you can calculate your net income.

  • Individual transactions which result in income and expenses being recorded will ultimately result in a profit or loss for the period.
  • The lenders of a business have the legal and economic rights to the assets of that business.
  • Double-entry accounting requires that every business transaction be marked in at least two financial accounts.
  • The balancing entry is a reduction in the equity of the shareholders.
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For example, a creditor who lends money to a restaurant owner has a right, in a legal sense, to a portion of the business’ assets until the business repays its debt. The owner of the business also has an interest in the assets because they have invested in the business. By making this an international standard, it’s easier for global corporations to keep track of their accounts. It’s also helpful on bookkeeping for startups a lower level by keeping all transactions in balance, with a verifiable relationship between each expense and its source of financing. Therefore cash (asset) will reduce by $60 to pay the interest (expense) of $60. $10,000 of cash (asset) will be received from the bank but the business must also record an equal amount representing the fact that the loan (liability) will eventually need to be repaid.

Seven accounting equation formulas to run a successful business

This can be a purchase, an increase in the company’s assets, a reduction in income, or an increase in expenses. The equity is what remains of the investment of the owners of the company, by the difference between the value of the assets and the value of the debts. The lenders of a business have the legal and economic rights to the assets of that business.

accounting equation

Owner’s equity will equal anything left from the assets after all liabilities have been paid. The assets of the business will increase by $12,000 as a result of acquiring the van (asset) but will also decrease by an equal amount due to the payment of cash (asset). Capital essentially represents how much the owners have invested into the business along with any accumulated retained profits or losses.


This basic equation offers a way for businesses to ensure that their financial statements are balanced. Any entries made on the debit side of a balance sheet should have a corresponding entry on the credit side. A trade receivable (asset) will be recorded to represent Anushka’s right to receive $400 of cash from the customer in the future. As inventory (asset) has now been sold, it must be removed from the accounting records and a cost of sales (expense) figure recorded. The cost of this sale will be the cost of the 10 units of inventory sold which is $250 (10 units x $25).

What are the 3 accounting equations?

  • Assets = Liabilities + Owner's Capital – Owner's Drawings + Revenues – Expenses.
  • Owner's equity = Assets – Liabilities.
  • Net Worth = Assets – Liabilities.

The process of recording these transactions will continue across the period. In reality, a business may have thousands, with each one affecting at least two accounts. The inventory asset is recorded and the obligation to pay the suppliers is reflected as a liability. Financial analysis often involves both using or analyzing historic information and forecasting forward-looking financial statements. A thorough understanding of the engineering behind financial statements is essential for a valuation assignment or an M&A transaction. By subtracting the cost of outputs from the cost of materials, you’ll know your cost of goods sold.