Accounting is the process of tracking your money and finances. It includes reporting, recording, analyzing and summarizing of transactions, it is also helpful to check the financial position of the business or the financial health of the business.
While accounting equation is an important part of accounting that shows everything a business owns (assets) is paid by borrowing money (liabilities) or by the owner’s own money (equity).
In this blog we will learn what the accounting equation is, its rules, types, examples, limitations, and some common questions beginners often ask.
What is Accounting Equation?
The accounting equation shows the relationship between a business’s assets, liabilities, and owner’s equity. It also tells us how the business is managing the money. It is the base of the double entry bookkeeping system, where every transaction affects two sides. It is a basic formula that keeps the balance sheet balanced.
The basic accounting equation is:
| Assets = Liabilities + Owner’s Equity |
This means whatever a business owns (assets) is funded by what it owes to others (liabilities) and the owner’s investment (equity).
Accounting Equation Rules & Formulas
The key rules of accounting equation:
- Assets are what the business owns and which have value and help them to generate money for the future and it is beneficial for the future as well. It includes cash, inventory, buildings, etc.
- Liabilities are what the business owes, it is mostly like the debt or obligation that needs to be paid by the business in future. It includes loans, bills, etc.
- Owner’s Equity is the owner’s share in the business, it includes the value left after subtracting all liabilities from the total business. It includes capital + profits – drawings.
Accounting Equation Formula:
| Assets = Liabilities + Owner’s Equity (it should always be equal) |
This formula always stays balanced, if a transaction affects one side, it also affects the other side equally. It is also helpful to record the financial data and check the financial position of the business.
Types of Accounting Equation
There are two main types:
1. Simple Accounting Equation
- Formula: Assets = Liabilities + Capital
- Used for sole proprietors or small businesses.
2. Expanded Accounting Equation
- Formula: Assets = Liabilities + Capital + Revenue – Expenses – Drawings
- This version includes income and expenses to explain changes in equity.
Accounting Equation Examples
Example 1: Starting a Business
Situation:
You start a new business and invest ₹1,00,000 of your own money into it.
What happens:
- Your business now has ₹1,00,000 in cash. That’s an asset.
- Since this money is your investment, it becomes your capital or owner’s equity in the business.
So, the equation becomes:
Assets (₹1,00,000) = Capital (₹1,00,000)
This means the money the business owns came from the owner’s investment. The equation is balanced so it will affect two accounts and it is easy to record the financial data.
Example 2: Buying Furniture on Credit
Situation:
Your business needs furniture, so you buy it for ₹20,000 but you don’t pay right away, you buy it on credit.
What happens:
- Your business gets furniture worth ₹20,000. This is an asset.
- Since you haven’t paid yet, you owe ₹20,000 this becomes a liability (called accounts payable).
So, the equation becomes:
Assets (₹1,00,000 cash + ₹20,000 furniture) = Liabilities (₹20,000) + Capital (₹1,00,000)
The total assets are ₹1,20,000 now and total of liabilities + capital is also ₹1,20,000. And, the equation is balanced.
Example 3: Earning from Sales
Situation:
You sell some products and earn ₹10,000 in cash, this is the income.
What happens:
- Your cash (asset) increases by ₹10,000.
- This income increases your owner’s equity, because profit belongs to the owner.
So, the equation becomes:
Assets (₹1,10,000 cash + ₹20,000 furniture) = Liabilities (₹20,000) + Owner’s Equity (₹1,10,000)
Again, both sides equal ₹1,30,000 the equation stays balanced.
These examples show how every business activity changes the accounting equation, but the balance is always being maintained to reduce errors, if the financial data is balanced it is easy to check the financial position of the business.
Limitations of Accounting Equation
1. It doesn’t show detailed performance like profits and losses:
The accounting equation tells us the overall financial position or financial health of the business, but it doesn’t explain how much profit or loss the business made. For that, we need the income statement to check the actual profit and loss of the business.
2. Can’t detect fraud or errors in transaction entries:
If a mistake or fraud happens but still keeps the equation balanced (for example, entering the wrong amount in two places), the error won’t be spotted just by looking at the equation so it is difficult to detect the fraud or errors.
3. Doesn’t show cash flow or liquidity directly:
The accounting equation won’t tell you if the business has enough cash to pay bills on time, it doesn’t reflect how money is moving in and out, for this we will prepare a cash flow statement to check the inflow and outflow of cash.
4. Focuses only on financial position, not the full picture of the business:
It shows assets, liabilities, and equity at a point in time, it doesn’t explain how the business is performing over time or what future risks it may face. It only focuses to check the actual financial position of the business not focuses on the full picture of the business like whether the business in profit or loss and how much cash business is generating.
Conclusion
Accounting equation is the base of the double entry system. It records the transaction in both accounts or affects both sides, it is also helpful to check the actual financial position of the business.
Whether you’re a student, a beginner, or a small business owner, understanding this formula will help you better manage your finances and it forms the backbone of all accounting records.
FAQs
1. Why is the accounting equation important?
It helps ensure that the balance sheet is always accurate and balanced after every transaction.
2. What are assets in the accounting equation?
Assets are everything a business owns, like cash, inventory, and equipment.
3. What is the owner’s equity?
Owner’s equity is the owner’s share in the business capital plus profits minus any drawings.
4. How does revenue affect the accounting equation?
Revenue increases owner’s equity, which increases assets if income is earned in cash.
5. Can the accounting equation be unbalanced?
No, if recorded correctly, the accounting equation will always remain balanced.
6. Is the accounting equation used in all types of businesses?
Yes, it applies to sole proprietors, partnerships, and companies though the terms may vary slightly.
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