The Accounting Equation

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Offline Repon

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The Accounting Equation
« on: June 26, 2015, 07:46:55 PM »
The Accounting Equation
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Definition of the Accounting Equation
The accounting equation is the basis upon which the double entry accounting system is constructed. In essence, the accounting equation is:
Assets = Liabilities + Shareholders' Equity
The assets in the accounting equation are the resources that a company has available for its use, such as cash, accounts receivable, fixed assets, and inventory.
The company pays for these resources by either incurring liabilities (which is the Liabilities part of the accounting equation) or by obtaining funding from investors (which is the Shareholders' Equity part of the equation). Thus, you have resources with offsetting claims against those resources, either from creditors or investors. All three components of the accounting equation appear in the balance sheet, which reveals the financial position of a business at any given point in time.
The Liabilities part of the equation is usually comprised of accounts payable that are owed to suppliers, a variety of accrued liabilities, such as sales taxes and income taxes, and debt payable to lenders.
The Shareholders' Equity part of the equation is more complex than simply being the amount paid to the company by investors. It is actually their initial investment, plus any subsequent gains, minus any subsequent losses, minus any dividends or other withdrawals paid to the investors.
You can see this relationship between assets, liabilities, and shareholders' equity in the balance sheet, where the total of all assets always equals the sum of the liabilities and shareholders' equity sections.
The reason why the accounting equation is so important is that is always true - and it forms the basis for all accounting transactions. At a general level, this means that whenever there is a recordable transaction, the choices for recording it all involve keeping the accounting equation in balance. The accounting equation concept is built into all accounting software packages, so that all transactions that do not meet the requirements of the equation are automatically rejected.
Accounting Equation Example
ABC International engages in the following series of transactions:
1.   ABC sell shares to an investor for $10,000. This increases the cash (asset) account as well as the capital (equity) account.
2.   ABC buys $4,000 of inventory from a supplier. This increases the inventory (asset) account as well as the payables (liability) account.
3.   ABC sells the inventory for $6,000. This decreases the inventory (asset) account and creates a cost of goods sold expense that appears as a decrease in the income (equity) account.
4.   The sale of ABC's inventory also creates a sale and offsetting receivable. This increases the receivables (asset) account by $6,000 and increases the income (equity) account by $6,000.
5.   ABC collects cash from the customer to which it sold the inventory. This increases the cash (asset) account by $6,000 and decreases the receivables (asset) account by $6,000.
 
Note how every transaction is balanced within the accounting equation - either because there are changes on both sides of the equation, or because a transaction cancels itself out on one side of the equation (as was the case when the receivable was converted to cash).
Recording accounting transactions with the accounting equation means that you use debits and credits to record every transaction, which is known as double-entry bookkeeping. See thedebits and credits article for more information about double-entry bookkeeping.
Sample Transactions
The following table shows how a number of typical accounting transactions are recorded within the framework of the accounting equation:
 Transaction Type                                                    Assets                                                               Liabilities + Equity
Buy fixed assets on credit                          Fixed assets increase                                          Accounts payable (liability) increases
Buy inventory on credit                                  Inventory increases                                           Accounts payable (liability) increases
Pay dividends                                                  Cash decreases                                                  Retained earnings (equity) decreases
Pay rent                                                           Cash decreases                                          Income (equity) decreases
Pay supplier invoices                                   Cash decreases                                           Accounts payable (liability) decreases
Sell goods on credit (part 1)                           Inventory decreases                                     Income (equity) decreases
Sell goods on credit (part 2)                           Accounts receivable increases                           Income (equity) increases
Sell services on credit                                   Accounts receivable increases                           Income (equity) increases
Sell stock                                                           Cash increases                                                   Equity increases

Here are examples of each of the preceding transactions, where we show how they comply with the accounting equation:
   Buy fixed assets on credit. ABC Company buys a machine on credit for $10,000. This increases the fixed assets (Asset) account and increases the accounts payable (Liability) account. Thus, the asset and liability sides of the transaction are equal.
   Buy inventory on credit. ABC Company buys raw materials on credit for $5,000. This increases the inventory (Asset) account and increases the accounts payable (Liability) account. Thus, the asset and liability sides of the transaction are equal.
   Pay dividends. ABC Company pays $25,000 in dividends. This reduces the cash (Asset) account and reduces the retained earnings (Equity) account. Thus, the asset and equity sides of the transaction are equal.
   Pay rent. ABC Company pays $4,000 in rent. This reduces the cash (Asset) account and reduces the accounts payable (Liabilities) account. Thus, the asset and liability sides of the transaction are equal.
   Pay supplier invoices. ABC Company pays $29,000 on existing supplier invoices. This reduces the cash (Asset) account by $29,000 and reduces the accounts payable (Liability) account. Thus, the asset and liability sides of the transaction are equal.
   Sell goods on credit. ABC Company sell goods for $55,000 on credit. This increases the accounts receivable (Asset) account by $55,000, and increases the revenue (Equity) account. Thus, the asset and equity sides of the transaction are equal.
   Sell stock.  ABC Company sells $120,000 of its shares to investors. This increases the cash account (Asset) by $120,000, and increases the capital stock (Equity) account. Thus, the asset and equity sides of the transaction are equal.
Additional Accounting Equation Issues
What if you print the balance sheet and the total of all assets do not match the total of all liabilities and shareholders' equity? There may be one of three underlying causes of this problem:
   Rounding error. If your accounting software is rounding to the nearest dollar or thousand dollars, the rounding function may result in a presentation that appears to be unbalanced.
   Unbalanced starting numbers. If you have just started using the software, you may have entered beginning balances for the various accounts that do not balance under the accounting equation. The accounting software should flag this problem when you are entering the beginning balances.
   Unbalanced transactions. You may have made a journal entry where the debits do not match the credits. This should be impossible if you are using accounting software, but is entirely possible (if not likely) if you are recording accounting transactions manually.
Nonprofit Accounting Equation
The equation differs for a nonprofit entity, since a nonprofit does not record any shareholders' equity. Instead, the equation for a nonprofit is as follows:
Assets = Liabilities + Net Assets
The net assets part of this equation is comprised of unrestricted net assets, temporarily restricted net assets, and permanently restricted net assets.

Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University

Offline asitrony

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Re: The Accounting Equation
« Reply #1 on: June 26, 2015, 07:48:34 PM »
Thanks for sharing such a effective post @ Ripon sir.

Are accounting equation similar to real mathematics?

Offline Repon

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Re: The Accounting Equation
« Reply #2 on: June 26, 2015, 07:59:10 PM »
Yes, it is similar to that and it can be proved mathematically. @ Rony
Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University

Offline asitrony

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Re: The Accounting Equation
« Reply #3 on: June 26, 2015, 08:01:17 PM »
Great!

it is really novel thing to me!

anyway, what do u mean by fixed asset?

It sounds very interesting to me......# Ripon

Offline Repon

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Re: The Accounting Equation
« Reply #4 on: June 26, 2015, 08:04:10 PM »
The another name of fixed assets are non-current assets or long-term assets. The assets which have lives more than 1 year are called fixed assets.Example: Building, Furniture.
Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University

Offline asitrony

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Re: The Accounting Equation
« Reply #5 on: June 26, 2015, 08:09:13 PM »
So, we all have fixed assets more or less!

Can we measure fixed asset?

Offline Repon

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Re: The Accounting Equation
« Reply #6 on: June 26, 2015, 08:13:12 PM »
Yes, we all have those.We can measure those also.
Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University

Offline asitrony

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Re: The Accounting Equation
« Reply #7 on: June 26, 2015, 08:16:42 PM »
nice idea!

I am struggling with the term' rounding error'.

Can you help me to come up?


#Ripon sir
« Last Edit: June 26, 2015, 08:18:44 PM by asitrony »

Offline Repon

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Re: The Accounting Equation
« Reply #8 on: June 26, 2015, 08:18:56 PM »
If your accounting software is rounding to the nearest dollar or thousand dollars, the rounding function may result in a presentation that appears to be unbalanced. Example: 12 is round but 12.33 is not a round number.
Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University

Offline Repon

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Re: The Accounting Equation
« Reply #9 on: June 26, 2015, 08:20:01 PM »
Do you have idea about dividend? @ Rony
Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University

Offline asitrony

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Re: The Accounting Equation
« Reply #10 on: June 26, 2015, 08:21:50 PM »
NO.
I don't have any idea regarding dividend?

Offline Repon

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Re: The Accounting Equation
« Reply #11 on: June 26, 2015, 08:24:16 PM »
Well. The portion of net profit of a company which is distributed among shareholders of that company is called dividend. @ Rony
Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University

Offline Repon

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Re: The Accounting Equation
« Reply #12 on: June 26, 2015, 08:28:34 PM »
Moreover, the portion of net profit which is kept aside is called retained earnings. @ Rony
Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University

Offline asitrony

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Re: The Accounting Equation
« Reply #13 on: June 26, 2015, 08:31:12 PM »
Now, I have a clear idea about dividend and retained earnings.

thanks sir, for your kind information!!!

Offline Repon

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Re: The Accounting Equation
« Reply #14 on: June 26, 2015, 08:48:30 PM »
Thank you also for showing interest in learning!
Senior Lecturer in Accounting
Department of Business Administration
Faculty of Business & Economics
Daffodil International University