The Accounting Equation

The Accounting Equation looks like this:

Assets (A) = Equity (E) + Liabilities (L)

 

If you’ve spent any amount of time in an accounting course or classroom, the formula above should not be new to you. You may have seen a different variant of this formula since, being an equation, it could be stated differently (eg. Equity = Assets - Liabilities)

If you have not heard of or seen this before let us now explore the role of the accounting equation.

Previously we’ve looked at the definitions of Assets, Liabilities and Equity. This helped us to understand what they are. The accounting equation helps us to understand how Assets, Liabilities and Equity relate to each other.

According to the equation the sum of all the business assets will always equal the total equity and liabilities.

Put another way: the value of all the cash, machinery, vehicles and other assets (Assets) will always be equal to the sum of the profits and monies contributed by the owners (Equity) and the monies borrowed from a third party (Liabilities).

Here’s how this makes sense: If a business buys a piece of equipment it can either use its own resources (cash or other assets) or the owner can contribute his personal assets  or it can turn to other sources for funding like banks or a combination of the two.

Note: Assets, Liabilities and Equity is sometimes also referred to as ‘The Balance Sheet’. This is because a Balance Sheet is precisely that: a statement that reflect the Assets, Liabilities and Equity of a person or business on a particular day.

Examples

 

Lets look at some transactions to help understand this better.

Example 1 - The owner of a company deposits R50,000 into the business bank account.

This exercise is all about paying attention to the way transactions like these affect the balance sheet. Here’s the solution to the first one.

Assets =

Equity +

Liabilities

+50,000

+50,000

0

Let’s analyse the effect this transaction has had on the Balance Sheet. Notice that Equity increased by R50,000. This is because the owner increased his stake in the business by R50,000. He is risking R50,000 more than before this transaction occurred.

Since cash is an asset, the total assets will increase by R50,000. The business bank account has R50,000 more than it had before this transaction.

 

Let’s have a look at another transaction.

Example 2 - A loan taken out by the business for a delivery vehicle R55,000.

Here’s the effect on the balance sheet:

Assets =

Equity +

Liabilities

+55,000

0

+55,000

Let’s analyse again. Taking out a loan increases the amount of money owed by the business to people outside the business (Liabilities). The effect is that Liabilities will increase by R55,000. Now that company has a new delivery vehicle, Assets increase by the same amount, keeping the equation in balance.

 

Example 3 - Purchased goods from a supplier on credit. These goods will be sold to customers at a profit. The goods were delivered together with an invoice for R25,000. Payment will only be made in 30 days from the end of the month.

Assets =

Equity +

Liabilities

+25,000

0

+25,000

Time to analyse. In the first instance we received the goods that will go into stock holding until we sell them or use them to manufacture goods.

There are many names used for this and you might have heard some of these before. Eg. stock, trading stock, inventory on hand to name a few.

So stock increases by R25,000. Stock is an Asset. Then we received an invoice for the goods which means we owe our supplier money. Or at least since we are not paying for the stock immediately it must be that we still owe them the money. This means Liabilities increase by R25,000.

 

Example 4 - Paid R10,000 Salaries for the Month from Bank Account.

Assets =

Equity +

Liabilities

-10,000

-10,000

0

Finally, we are spending money! So our bank account (our asset) decreases by R10,000. We had R55,000 and spent R10,000.

Salaries are expenses. Expenses decrease profits so Equity decreases by R10,000.

It is good to remember that the Trading Account, that is; the income(+) and expenses(-); form part of Equity. This will really help you make sense of things.

 

Example 5 - Sold Goods from stock (Value R20,000) for R35,000. Customer Paid via EFT.

Assets =

Equity +

Liabilities

+35,000

-20,000

+35,000

-20,000

0

So this is a two part transaction. First we need to deal with the sale. Then we need to account for the cost of sales.

First the sale. Since we have R35,000 more cash in bank, assets have increased. Sales have increased too. Therefore Equity increased by R35,000.

Now the cost of the sale. R20,000’s worth of stock in our stock store has been sold. So the effect this transaction had on the balance sheet is to decrease the value of stock on hand. It also affects the Equity of the business in that it is Cost of Sales. Cost of Sales decreases overall profit.

 

Example 6 - Spent R5,000 in cash on some Equipment.

Assets =

Equity +

Liabilities

+5,000

-5,000

0

0

In this case we are only working on one side of the equation. Since we are spending money from our bank account our assets decrease by the R5,000. But we are buying equipment which is also an asset. The result is that Assets increase by R5,000 as well.

A thorough grasp of the accounting equation will help to deal with transactions later on in this tutorial. I highly recommend you spend some time here before moving on.