Basic Accounting Equation

Accounting

Understanding the basic accounting equation is essential in learning and doing the accounting process. This equation is often used in the accounting procedures, from recording until interpretation of the financial data.

What is the Basic Accounting Equation?

Basic Accounting Equation states that the business resources (assets) are attributable to the amount owed to creditors (liabilities) and capital invested by the owners (equity). It is formulated as follows:

ASSET = LIABILITY + EQUITY

  • Asset pertains to the resources available and used in sustaining the operation of the business. It includes cash, accounts receivable, inventory, office supplies, equipment, building, land, goodwill, patent, etc.
  • Liability refers to the amount of debts owed to outside person or entity, known as creditors. It represents the claim of creditors in the assets of the business. It includes accounts payable, loans payable, notes payable, bonds payable, unearned revenue, etc.
  • Equity is the amount of capital or resources invested in the business by the owner(s). It represents the claim of owners in the assets of the business. It consist of capital, drawing, common stock, additional paid in capital, preferred stock, retained earnings, net income, net loss.

Rules on Basic Accounting Equation

1. Both side of the Basic Accounting Equation should be equal and balance.

Example:
The business, XYZ Company, has total assets amounting to $1,000, amount of debt and capital totaling $250 and $750, respectively.

Asset = Liability + Equity
$1,000 = $250 + $750
$1,000 = $1,000

Note: Total amounts on both sides are equal.

2. For every valid business transaction recorded should affect or change two accounts. It means that in every value received, another value is given up. This is also referred to as double-entry recording.

Look at the following instances:

a. Increase in asset account should have an equivalent increase in liability or equity account. As shown in Example 1 and 2.

Example # 1:
Joe Smith, sole proprietor of XYZ Company, invested cash amounting to $10,000 to start and operate his accounting software company.

Asset = Liability + Equity
Cash $10,000 = 0 + $10,000 J.Smith, Capital

Note: The cash invested affected two accounts which are cash (asset) and capital (equity) account.

Example # 2:
XYZ Company was granted a bank loan from ABC Bank amounting to $4,000.

Asset = Liability + Equity
Cash $4,000 = $4,000 Loans Payable + 0

Note: The cash loan received from bank affected two accounts which are cash (asset) and loans payable (liability) account.

b. Decrease in asset account should have an equivalent decrease in liability or equity account. As shown in Example 3 and 4.

Example # 3:
Joe Smith withdraws cash amounting to $500 from the business for his personal use.

Asset = Liability + Equity
Cash ($500) = 0 + ($500) J.Smith, Capital

Note: The cash withdrawal of Joe indicates that it was used for personal purposes, as such, it is considered as capital withdrawal.

Parenthesis () represents decrease in amount or value.

Example # 4:
XYZ Company paid in cash the partial amount of its loan to ABC Bank amounting to $2,500.

Asset = Liability + Equity
Cash ($2,500) = ($2,500) Loans Payable  + 0

Note: The amount of cash paid to ABC Bank represents payment of bank loans. As such, there will be an equivalent decrease on both cash (asset) and loans payable (liability) account.

c. Increase or decrease may affect two accounts on one side of the equation. As shown in Example # 5.

Example #5:
XYZ Company purchased office supplies amounting to $250 paid on cash.

Asset = Liability + Equity
Cash ($250) = 0 + 0
Office Supplies $250 = 0 + 0

Note: The example affected both asset accounts. Cash decreased by $250 while office supplies increased by $250.

Comments

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  21. How does it show if the owner takes supplies for personal use?

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