3. Accounting Equation

Meaning of Accounting Equation

The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner’s equity of a person or business. It is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. At any given time, the relationship is expressed as follows:

Economic resources= Claims

Another term for economic resources is assets. Claims consist of owners’ claims or owners’ equity & creditors’ claims or liabilities. Thus above equation can be expressed as follows:

Assets= Owners’ equity + Liabilities

                  Or

Assets= Capital’ + Liabilities

 

Elements of Accounting: Assets, Liabilities, and Capital

The three major elements of accounting are: Assets, Liabilities, and Capital.

These terms are used widely in accounting so it is necessary that we take a close look at each element. But before we go into them, we need to understand what an “account” is first.

 

What is an Account?

The term “account” is used often in this tutorial. Thus, we need to understand what it is before we proceed. In accounting, an account is a descriptive storage unit used to collect and store information of similar nature.

For example, “Cash”.

Cash is an account that stores all transactions that involve cash receipts and cash payments. All cash receipts are recorded as increases in “Cash” and all payments are recorded as deductions in the same account.

Another example, “Building”. Suppose a company acquires a building and pays in cash. That transaction would be recorded in the “Building” account for the acquisition of the building and a reduction in the “Cash” account for the payment made.

Now, let’s take a look at the accounting elements.

Assets

Assets refer to resources owned and controlled by the entity as a result of past transactions and events, from which future economic benefits are expected to flow to the entity. In simple terms, assets are properties or rights owned by the business. They may be classified as current or non-current.

A. Current assets – Assets are considered current if they are held for the purpose of being traded, expected to be realized or consumed within twelve months after the end of the period or its normal operating cycle (whichever is longer), or if it is cash. Examples of current asset accounts are:

  1. Cash and Cash Equivalents – bills, coins, funds for current purposes, checks, cash in bank, etc.
  2. Receivables – Accounts Receivable (receivable from customers), Notes Receivable (receivables supported by promissory notes), Rent Receivable, Interest Receivable, Due from Employees (or Advances to Employees), and other claims
    Allowance for Doubtful Accounts – This is a valuation account which shows the estimated uncollectible amount of accounts receivable. It is a contra-asset account and is presented as a deduction to the related asset – accounts receivable.
  3. Inventories – assets held for sale in the ordinary course of business
  4. Prepaid expenses – expenses paid in advance, such as, Prepaid Rent, Prepaid Insurance, Prepaid Advertising, and Office Supplies

B. Non-current assets – Assets that do not meet the criteria to be classified as current. Hence, they are long-term in nature – useful for a period longer that 12 months or the company’s normal operating cycle. Examples of non-current asset accounts include:

  1. Long-term investments – investments for long-term purposes such as investment in stocks, bonds, and properties; and funds set up for long-term purposes
  2. Land – land area owned for business operations (not for sale)
  3. Building – such as office building, factory, warehouse, or store
  4. Equipment – Machinery, Furniture and Fixtures (shelves, tables, chairs, etc.), Office Equipment, Computer Equipment, Delivery Equipment, and others
    Accumulated Depreciation – This is a valuation account which represents the decrease in value of a fixed asset due to continued use, wear & tear, passage of time, and obsolescence. It is a contra-asset account and is presented as a deduction to the related fixed asset.
  5. Intangibles – long-term assets with no physical substance, such as goodwill, patent, copyright, trademark, etc.
  6. Other long-term assets

 

Liabilities

Liabilities are economic obligations or payables of the business.

Company assets come from 2 major sources – borrowings from lenders or creditors, and contributions by the owners. The first refers to liabilities; the second to capital.

Liabilities represent claims by other parties aside from the owners against the assets of a company.

Like assets, liabilities may be classified as either current or non-current.

A. Current liabilities – A liability is considered current if it is due within 12 months after the end of the balance sheet date. In other words, they are expected to be paid in the next year.

If the company’s normal operating cycle is longer than 12 months, a liability is considered current if it is due within the operating cycle.

Current liabilities include:

  1. Trade and other payables – such as Accounts Payable, Notes Payable, Interest Payable, Rent Payable, Accrued Expenses, etc.
  2. Current provisions – estimated short-term liabilities that are probable and can be measured reliably
  3. Short-term borrowings – financing arrangements, credit arrangements or loans that are short-term in nature
  4. Current-portion of a long-term liability – the portion of a long-term borrowing that is currently due.
    Example: For long-term loans that are to be paid in annual installments, the portion to be paid next year is considered current liability; the rest, non-current.
  5. Current tax liabilities – taxes for the period and are currently payable

B. Non-current liabilities – Liabilities are considered non-current if they are not currently payable, i.e. they are not due within the next 12 months after the end of the accounting period or the company’s normal operating cycle, whichever is shorter.

In other words, non-current liabilities are those that do not meet the criteria to be considered current. Hah! Make sense? Non-current liabilities include:

  1. Long-term notes, bonds, and mortgage payables;
  2. Deferred tax liabilities; and
  3. Other long-term obligations

 

Capital

Also known as net assets or equity, capital refers to what is left to the owners after all liabilities are settled. Simply stated, capital is equal to total assets minus total liabilities. Capital is affected by the following:

  1. Initial and additional contributions of owner/s (investments),
  2. Withdrawals made by owner/s (dividends for corporations),
  3. Income, and
  4. Expenses.

Owner contributions and income increase capital. Withdrawals and expenses decrease it.

The terms used to refer to a company’s capital portion varies according to the form of ownership. In a sole proprietorship business, the capital is called Owner’s Equity or Owner’s Capital; in partnerships, it is called Partners’ Equity or Partners’ Capital; and in corporations, Stockholders’ Equity.

In addition to the three elements mentioned above, there are two items that are also considered as key elements in accounting. They are income and expense. Nonetheless, these items are ultimately included as part of capital.

Income

Income refers to an increase in economic benefit during the accounting period in the form of an increase in asset or a decrease in liability that results in increase in equity, other than contribution from owners.

Income encompasses revenues and gains.

Revenues refer to the amounts earned from the company’s ordinary course of business such as professional fees or service revenue for service companies and sales for merchandising and manufacturing concerns.

Gains come from other activities, such as gain on sale of equipment, gain on sale of short-term investments, and other gains.

Income is measured every period and is ultimately included in the capital account. Examples of income accounts are: Service Revenue, Professional Fees, Rent Income, Commission Income, Interest Income, Royalty Income, and Sales.

Expense

Expenses are decreases in economic benefit during the accounting period in the form of a decrease in asset or an increase in liability that result in decrease in equity, other than distribution to owners.

Expenses include ordinary expenses such as Cost of Sales, Advertising Expense, Rent Expense, Salaries Expense, Income Tax, Repairs Expense, etc.; and losses such as Loss from Fire, Typhoon Loss, and Loss from Theft. Like income, expenses are also measured every period and then closed as part of capital.

Net income refers to all income minus all expenses.

 

The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner’s equity of a person or business. It is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as furthermore: thumb

Assets = Liabilities + Equity 
A = L + E
Assets = Stockholder Equity + Liabilities
a = o e + l 

In a corporation, capital represents the stockholders’ equity. Since every business transaction affects at least two of a company’s accounts, the accounting equation will always be “in balance,” meaning the left side should always equal the right side. Thus, the accounting formula essentially shows that what the firm owns (its assets) is purchased by either what it owes (its liabilities) or by what its owners invest (its shareholders’ equity or capital).

The formula can be rewritten:

Assets – Liabilities = (Shareholders’ or Owners’ Equity)

Now it shows owners’ equity is equal to property (assets) minus debts (liabilities). Since in a corporation owners are shareholders, owner’s equity is called shareholders’ equity. Every accounting transaction affects at least one element of the equation, but always balances. Simple transactions also include:

Transaction
Number
Assets Liabilities Equity Explanation
1 + 6,000 + 6,000 Issuing stocks for cash or other assets
2 + 10,000 + 10,000 Buying assets by borrowing money (taking a loan from a bank or simply buying on credit)
3 900 900 Selling assets for cash to pay off liabilities: both assets and liabilities are reduced
4 + 1,000 + 400 + 600 Buying assets by paying cash by shareholder’s money (600) and by borrowing money (400)
5 + 700 + 700 Earning revenues
6 200 200 Paying expenses (e.g. rent or professional fees) or dividends
7 + 100 100 Recording expenses, but not paying them at the moment
8 500 500 Paying a debt that you owe
9 0 0 0 Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities

These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.

This equation is part of the transaction analysis model, for which we also write

Owner’s equity = Contributed Capital + Retained Earnings
Retained Earnings = Net Income − Dividends

and

Net Income = Income − Expenses

The equation resulting from making these substitutions in the accounting equation may be referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation.

Assets = Liabilities + Contributed Capital + Revenue – Expenses – Dividends
What is the basic accounting equation?
  1. Assets = Liabilities + Equity
  2. Liabilities = Assets – Equity
  3. Equity = Assets – Liabilities
  4. Assets = Liabilities + Owner’s Equity + Revenue – Expenses – Draws

Why the accounting equation is important

The accounting equation can give you a clear picture your business’s financial situation. You must calculate the accounting equation to read your balance sheet. The accounting equation helps you understand the relationship between your financial statements.

By using the accounting equation, you can see if you can fund the purchase of an asset with your business’s existing assets. And, the equation will reveal if you should pay off debts with assets (like cash) or by taking on more liabilities.

 

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