What is the Basic Accounting Equation?
The formula for the basic accounting equation is written as:
Assets = Liabilities + Shareholder Equity
The basic accounting equation shows the connection between assets, liabilities and equity in a business.
It forms the foundation upon which the double entry accounting system is built.
Therefore, when businesses record accounting transactions, they would need to follow the basic accounting equation to ensure all of the information in their records is accurate.
After each transaction, the basic accounting equation should remain in balance.
What are the 3 Elements of the Accounting Equation?
The accounting equation consists of three elements: assets, liabilities, and shareholder equity. These are all recorded on the balance sheet of a business.
- Assets: These are the resources or items of value that a business owns. Examples include cash, equipment, inventory, buildings, and accounts receivable (money owed to the business by customers).
- Liabilities: These are essentially debts that a business owes to external parties. Examples include bank loans, accounts payable (money owed by the business to suppliers), and accrued expenses (unpaid bills).
- Shareholder Equity: Also known as owner’s equity or just simply ‘equity’. This represents the remaining interest in the assets after the liabilities have been deducted. Put simply, it’s the owner’s claim on the business’s assets. Examples include capital contributed by the owner, retained earnings (profits reinvested in the business), and any additional investments made by the owner.
Other Names for the Accounting Equation
The accounting equation is also known by several other names, including:
- Balance Sheet Equation: This name highlights the role of balance sheet in forming the accounting equation, as it shows the assets, liabilities, and shareholder equity of a business, recorded on the balance sheet.
- Fundamental Accounting Equation: This name highlights the primary and underlying nature of this equation in accounting.
Rearranged Accounting Equation
The basic accounting equation formula can also be rearranged as below:
Shareholder Equity = Assets – Liability
Liabilities = Shareholder Equity – Assets
If we take a step back and think about this rearranged accounting equation, it should make a lot of sense.
Shareholder equity essentially refers to the ownership of a business – and we can summarise a business as being the assets, minus any liabilities – ie what the business owns, minus anything it has to pay to others.
For example, in a farming business, the assets would be the land and cattle, and the liabilities would be any debts and creditors they owe money too.
Why Is the Accounting Equation Important?
The accounting equation is important for businesses as it forms the foundation of all accounting transactions that are recorded using the double entry system.
By adhering to the accounting equation, businesses can establish their total assets, liabilities, and equity, enabling them to understand their financial health and net worth at any given time.
Also, the accounting equation is essential in the preparation of accurate financial statements and annual reports.
Preparing a balance sheet provides a complete overview of a business’s assets, liabilities, and shareholder equity. In turn, this allows stakeholders such as investors, creditors, and management to assess the financial performance and stability of the business.
Using the accounting equation also helps businesses to detect errors and inconsistencies in financial transactions.
If the equation fails to balance, it indicates that mistakes have been made in recording transactions or reconciling accounts This will then encourage businesses to investigate and fix the issues quickly.
Examples of the Accounting Equation
To further illustrate the basic accounting equation, let’s look at some examples of how it works using a double entry system, and the specific business activities that affect the basic accounting equation:
Imagine a business with total assets worth £100,000. Therefore, the sum of the businesses liabilities plus shareholder equity would also equal £100,000. Let’s assume that liabilities are £50,000, and shareholder equity is £50,000.
Assets £100,000 = Liabilities £50,000 + Shareholder Equity £50,000
If the business takes out a loan of £50,000 from a bank, their assets will increase by £50,000, and because the loan is now owed to the bank, the liabilities will increase by £50,000:
Assets £100,000 + £50,000 cash = [Liabilities £50,000 + £50,000 loan] + Shareholder Equity £50,000
Assets £150,000 = Liabilities £100,000 + Shareholder Equity £50,000
Let’s do another example.
The business makes a profit of £100,000 over the year. Therefore, the assets of the business have increased by £100,000. Likewise, the shareholder equity increases by £100,000, as:
Shareholder Equity = Assets – Liability
Assets £100,000 + £100,000 profit/cash = Liabilities £50,000 + [Shareholder Equity £50,000 + £100,000 profit]
Assets £200,000 = Liabilities £50,000 + Shareholder Equity £150,000
Let’s do one more example.
Imagine the business buys some new machinery for £75,000 on credit.
The business would receive the new machinery, which is an asset, but as the purchase is on credit, it would increase the liability of the business.
Assets £100,000 + £75,000 machinery = [Liabilities £50,000 + £75,000 credit debt] + Shareholder Equity £50,000
Assets £175,000 = Liabilities £125,000 + Shareholder Equity £50,000
If you are ever in doubt, remember the three accounting equation formulas:
Assets = Liabilities + Shareholder Equity
Shareholder Equity = Assets – Liability
Liabilities = Shareholder Equity – Assets
Accounting Equation for Non-profit Entities
The basic accounting equation differs for a non-profit entity.
Remember that a non-profit organisation is an entity which exists for purposes other than for profit. These are usually for charitable purposes, promotion of culture and sports and welfare of society.
Consequently, a non-profit entity does not record any shareholder equity.
Instead, the equation for a non-profit is as follows:
Net Assets = Assets – Liabilities
In other words, the value of a non-profit entity is just the difference between what you own (assets) and your debt to others (liabilities).