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Accounting Equation

Accounting Equation Definition:
If we want to show the Statement of Financial Position (also known as “Balance Sheet”) in its simplest or easy to understandable shape it can only be done by Accounting Equation. So we define accounting equation as “the simplified representation of the statement of financial position.”

Accounting Equation:

Assets            =          Equity         +        Liabilities

So basically accounting equation is the one-liner statement of financial position where assets are equal to the combined total of equity plus liabilities. Every business transaction has its financial impact on the business entity that affects the accounting equation but ultimately accounting equation remains true. And it can only be possible if both aspects of business transaction (according to double-entry Bookkeeping system every transaction has two aspects i.e. debit side and credit side, and should be recorded accordingly.) reach its logical ends. One aspect of the business transaction contributes to the assets side of accounting equation while other on the equity plus liabilities side of the accounting equation with equal amount and as a result accounting equation remains satisfied. There are business transactions of which both aspects contribute to the same side of the accounting equation. One aspect of the business transaction contributes positively (Increase in value) while the other contributes negatively (decrease in value) that results in no change in total amount of that side of accounting equation and therefore it remains satisfied.

Accounting Equation
Accounting Equation

Explanation:

Effects of Financial Transactions on the Accounting Equation:

Let’s assume a newly established business and look the impact of business transactions on accounting equation. The probable series of transactions when one decides to setup a business are as follows:

  1. Introduction of capital
  2. Purchase of asset on cash
  3. Purchase of asset on credit
  4. Purchase of inventory on cash
  5. Purchase of inventory on credit
  6. Cash sales
  7. Credit sales
  8. Borrowing money
  9. Cash received from customers
  10. Payment to suppliers
  11. Drawings (Both in cash & in kind)
  12. Loan repayment

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