The Accounting Equation

The accounting equation is the basic equation which helps us to understand the relationship between different types of accounts and also give the basis for one of the financial statements, the balance sheet.

In its most simple form the accounting equation says that:

Assets = Liabilities

In the separate entity principle we spoke about how any money put into the business by owners are owed back out, so in this sense is a liability. In real term we treat the capital account of the owner as separate from the liabilities it allows us to view the equation as:

Assets = Liabilities + Capital

This effectively says that all of the things that we have (assets) have been financed in one of 3 ways either:-

  1. The owner invested capital to buy it (capital)
  2. The business made profit and bought it from that (capital)
  3. We still owe the money for it (liabilities)

This version of the accounting equation can be re-arranged to be shown as:

Assets – Liabilities = Capital

This is the most common form of the accounting equation.  It is also the form which introduces us to the layout of the balance sheet, a statement of the financial position of the business at a particular moment in time.

If we look at a simple transaction, Michael starts a business and puts £4,000 into the bank account, we can now look at both the dual effect and also the accounting equation following it.

Effect 1: We have £4,000 in the bank account (ASSET)

Effect 2: Michaels capital account is now £4,000 (CAPITAL)

Following on from this transaction we can say that the accounting equation is:

Assets – Liabilities = Capital

4,000 – 0 = 4,000

We must also remember that profit earned by the business will increase the amount of the capital account and also drawings taken out of the business by the owner will reduce the amount of the capital in the business.

So the full equation is actually:

Assets – Liabilities = Capital + Profit – Drawings

Once the accounting equation begins to come more involved, usually because more transactions have happened, we can start to get a picture of what the financial position of the company is.  In this case it is strong, i.e it has assets and no liabilities.