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Home / Finance / What is the basic accounting equation

What is the basic accounting equation

Last updated on August 26, 2024 by CA Bigyan Kumar Mishra

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Company’s balance sheet has three major sections: assets, liabilities and owner’s equity. As a general accounting rule, assets must equals liabilities and owner’s equity. It’s known as balance sheet equation or basic accounting equation, which is the foundation of the double-entry accounting system.

The basic accounting equation given below is a simple algebraic formula which ensures that the balance sheet remains balanced.

Asset = liabilities + Owners equity

This basic accounting equation states how three major components of a balance sheet are associated with each other.

Double entry system of bookkeeping ensures that each accounting entry made on the debit side should have a corresponding entry on the credit side to keep the equation balanced.

For instance, if a business takes out a loan from a bank, the borrowed capital will raise assets and the loan amount will also raise liabilities. In this way, the accounting equation will tally with the increase in asset and increase in liability.

Similarly, if a company buys raw material by paying cash, it will increase inventory (assets) and reduce cash (asset). In this way, the left side of the basic accounting equation will always tally with the right side value.

Assets – Left side of basic accounting equation

Assets are shown on the balance sheet as resources owned or controlled by a company. It includes;

  • Cash and cash equivalent,
  • Accounts receivable,
  • Inventory,
  • Equipment,
  • Land, and
  • Investments

Liabilities

Liabilities shown on the balance sheet are the company’s obligations as on the reporting date. Companies need to pay it to keep running its business. Common examples of liabilities includes;

  • Accounts payable
  • Long-term debt
  • Short-term debt
  • Rent payable
  • Salaries and wages payable
  • Utilities payable

Owner’s equity

Owner’s equity or shareholders equity/capital represents the value of the interest in the assets of the company. Shareholders create interest by contributing to the capital of the company and by retaining the profits over the years. This means it includes two things;

  • Invested capital
  • Retained earnings

You can get the owner’s capital by subtracting liabilities from assets. It’s also referred to as net assets and net worth.

Owner’s equity on the balance sheet represents the amount that has to be returned to shareholders if the company is liquidated on the date of reporting.

We know that owner’s equity is share capital of investors plus retained earnings. Therefore, the equation can be derived as follows;

Asset = liabilities + common stock or invested capital + retained earnings

We know that, Retained earnings = opening balance of retained earnings + net profits – dividends

Net profit = Revenue – expenses

After replacing retained earnings and net profit with the above two equation, basic accounting equation can be derived as follows;

Assets = liabilities + common stock + opening balance of retained earnings + Revenue – expenses – dividends

You can calculate the value of company equity by rearranging basic accounting equation as stated below:

Equity = Assets – liabilities

From this accounting equation, equity can be defined as the excess value, if any, of the assets of a company over the value of the liabilities.

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Categories: Finance

About the Author

CA Bigyan Kumar Mishra is a fellow member of the Institute of Chartered Accountants of India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.

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