Accounting Equation

The basic accounting equation is the foundation for the double-entry bookkeeping system. It shows how assets were financed: either by borrowing money from someone else (liability) or by paying your own money (shareholder's equity).

Assets = Liabilities + Shareholders/Owners equity^[1]

How it works

For example, say a student buys a computer for $945. This student borrowed $500 from his best friend and saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.

The formula can be re-written:

Assets - Liabilities = Shareholders/Owners equity^[2]

Now it shows that owner's interest is equal to property (assets) minus debts (liabilities). Since in a company owners are shareholders, owner's interest is called shareholder's equity. Every accounting transaction affects at least one element of the equation, but always balances. Simplest transactions also include:^[3]

Transaction                                      Shareholders'
   Number         Assets      =  Liabilities  +     equity
-----------    -------------     -----------     -------------
     1.        + 6,000                              +6,000
     2.        +10,000             +10,000
     3.        -   900             -900
     4.        + 1,000             +450             +   550
     5.        +   700                              +  700
     6.        -   200                              -  200
     7.                            +   100          -  100
     8.        -   500             -   500
     9.        +   200             -200

Explanation of transactions:

1. issuing stocks for cash or other assets;
2. buying assets by borrowing money (taking a loan from a bank or simply buying on credit);
3. selling assets for cash (in essence, it's just an exchange of one asset to another);
4. buying assets by paying cash (550) and by borrowing money (450);
5. earning revenues;
6. paying expenses (e.g., rent or professional fees) or dividends;
7. recording expenses, but not paying them at the moment;
8. paying on a debt that you owe;
9. receiving cash for sale of an asset

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.

Balance sheet

An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity and makes sure it balances (thus its name).

History

Luca Pacioli is notable for including the first published description of the method of keeping accounts that Venetian merchants used during the Italian Renaissance, known as the double-entry accounting system. Also, David Flath^{[citation needed]} asserts that Japanese merchants have used double-entry accounting for centuries:

assets= liabilities+capital+ additional investments + revenue or income - withdrawals -expenses or losses

References

Donate to Wikimedia