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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 (liability) or by paying your own money (shareholders' equity).
- Assets = Liabilities + (Shareholders or Owners equity)1
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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 or Owners equity)2
Now it shows 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 Number |
Assets | Liabilities | Shareholder's Equity |
Explanation | |||
|---|---|---|---|---|---|---|---|
| 1 | + | 6,000 | + | 6,000 | Issuing stocks for cash or other assets | ||
| 2 | + | 10,000 | + | 10,000 | Buying assets by borrowing money (taking a loan from a bank or simply buying on credit) | ||
| 3 | - | 900 | - | 900 | Selling assets for cash to pay off liabilities: both assets and liabilitiies are reduced | ||
| 4 | + | 1,000 | + | 400 | + | 600 | Buying assets by paying cash by shareholder's money (600) and by borrowing money (400) |
| 5 | + | 700 | + | 700 | Earning revenues | ||
| 6 | - | 200 | - | 200 | Paying expenses (e.g. rent or professional fees) or dividends | ||
| 7 | + | 100 | - | 100 | Recording expenses, but not paying them at the moment | ||
| 8 | - | 500 | - | 500 | Paying a debt that you owe | ||
| 9 | 0 | 0 | 0 | Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities | |||
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.
Also, the equation can be re-written as:
- Assets = Liabilities + Owners equity + (Revenue - Expenses)
This is often referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation. 4
Balance sheet
An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity, as well as totals to ensure that it balances.
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.
References
- ^ Meigs and Meigs. Financial Accounting, Fourth Edition. McGraw-Hill, 1983. p.19.
- ^ Meigs and Meigs.Financial Accounting, Fourth Edition. McGraw-Hill, 1983. p.20.
- ^ Accounting equation explanation with examples, accountingcoach.com.
- ^ Wild.Financial Accounting, Third Edition.McGraw-Hill, 2005. p.13
