Accounting Equation Approach

You must have heard that accounts are formed based on a double-entry system, i.e. whenever a transaction takes place, if one account gets debited, the other gets credited. And that is exactly what forms the basis for the accounting equation, also known as the balance sheet equation or basic accounting equation.

An accounting equation is a way of displaying that the company’s total assets are equal to the sum of its liabilities and the capital, i.e. equity held by the owners/shareholders.

ASSETS = LIABILITIES + CAPITAL

How is an Accounting Equation Formed and What Does it Mean?

Now, what is an accounting equation approach? What is a correct accounting equation?

Three main elements comprise the whole accounting equation: assets, liabilities, and capital. 

Assets are resources owned by the organisation for its benefit. They can include cash and cash equivalents, inventory, debtors, etc.

Liabilities represent the money paid and owed by the organisation to its outsiders, for example, creditors, rent, wages, etc.

And capital is the money put in by the owners, be it a firm or company (shareholder’s equity). It also includes retained earnings.

As we can deduce from the equation itself, liabilities and capital finance the whole of the organisation’s assets. 

Thus, a balanced correct accounting equation can represent whether or not all the recordings are in line with the double-entry accounting system, and the books and accounts are being shown at their fair values.

We can also rearrange the above-given equation to deduce that the shareholder’s equity is equal to total liabilities subtracted from total assets, which can also mean that if a company’s assets are being realized, the outsiders receive the first claim and what remains belongs to the shareholders.

Accounting Equation Examples

To understand the above theory of accounting equation approach and correct accounting equation better, let us take some practical accounting equation examples:

• Purchased furniture with cash

When this transaction takes place, furniture (an asset) is added, and cash (an asset) is reduced. This simultaneous debit and credit of assets have a zero net effect, and the accounting equation remains balanced.

• Purchased furniture with cash and credit

In this transaction, furniture (an asset is added), cash (an asset) is reduced, but credit (a liability) is added. Even after the simultaneous debit and credit, the accounting equation remains balanced

• Introduced capital in the business

In this transaction, with capital (right side of the equation) being introduced in the business, cash (an asset) is added, which brings the result of the accounting equation being perfectly balanced.

• Paid the creditor in cash

In this transaction, creditors (a liability) are reduced on the right side of the equation. On the other hand, cash (an asset) is being reduced on the left side of the equation, which leaves the final accounting equation completely balanced.

• Sold goods on debt and then collected the debt

This transaction has two different parts. In the first half, stock (an asset) is reduced, and debtors (an asset) are created. In the second half, the debtor (assets) is reduced, whereas cash (an asset) is added to the business. As you can see below, this simultaneous debit and credit has a zero net effect and leaves the final accounting equation balanced.

Limitations

The accounting equation is more of a measure to maintain the transactions’ mathematical and recording accuracy. The investors cannot trust the equation only for the actual impact of the transactions. They have to consider other things to understand them better and then invest in the company.

Conclusion

The accounting equation is a simple but very important concept in accounts to move forward with other concepts and to understand them better. A correct accounting equation can simplify a lot of things, and an accounting equation approach properly taken paves the way for other transactions.