Introduction

In business, the accounting equation is used to help us understand how assets, liabilities, and
owners equity relate to each other along with measures the financial position of a company. The
equation is set up as Assets = Liabilities + Owners Equity for an unincorporated business and
Assets = Liabilities + Stockholders Equity for larger corporations. Assets are the business
owned resources, such as money, building, equipment, and inventory. For assets in the equation,
it must equal the liabilities plus owners equity amount. Liabilities are what companies or small
business owe and is considered their duty. Liabilities can be viewed in two ways, as claims by
creditors against the company's assets, and a sourcealong with owner or stockholder equity
of the company's assets. Finally, the owners equity is what remains after you deduct the
liabilities away from the assets. In any transaction, the expressions get altered in order to fit the
equation and make the numbers equal properly. A balance sheet is a financial statement that
reports the assets and claims to those assets at a specific point in time (Kimmel, 2011). It is very
similar to the account equation in the sense that it shows a businesss total cash assets, which is
equal to the number of total liabilities added to its owners total equity. An example of this would
be if the assets of a company are $6,000 and there is no effect with the liabilities, then the
owners equity would equal $6,000. It would be set up as Assets ($6,000) = Liabilities (No
Effect) + Owners equity ($6,000). The account equation is a very useful tool to have in business
to help understand the position of a company.
Assets
Assets are anything of value that a company owns, which includes cash as well. Several types of
assets exist, such assets are as follows: Current, investments, capital, and intangible. These assets
are all combined for a companys total assets. Current assets are assets with dollar amounts that
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continually change. Such assets may include cash, inventory, raw materials, and raw materials.
Investments can be owned by companies which may include securities such as stocks and bonds.
Capital assets are permanent things that a company may own. This would include land,
buildings, vehicles, and equipment. Other things such as computers, appliances, and furniture
can also be considered capital assets as long as they are being used and not being sold. Intangible
assets include patents, copyrights and other non-material assets that have value.
Liabilities
Liabilities are anything a company owes to businesses or other people; there are two types of
liabilities. Current liabilities are liabilities that are usually paid within a year. Such liabilities
consist of money owed to vendors, suppliers, employees, short-term loans, and other bills. Long
term liabilities are liabilities that extend past a year. This may include bills such as a mortgage.
Owners Equity
Owners' equity, also called capital, is any debt owed to the business owners. For example, if you
invested $50,000 of your savings to start a business, that amount is recorded in a capital account,
also referred to as an owners'-equity account. In publicly traded companies, outstanding
preferred and common stock also represents owners' equity. A business will also record their
revenues and expenses in capital accounts due to the fact that it relates to how much money is
made over time. At the end of the cycle, the profits get transferred to a capital amount.

Principle illustration

To illustrate the principles, we will follow through, in a simplified form, the transactions of a
small business in its first month of trading.
Peter having spent 30 years as an insurance clerk, decides to take the plunge and invest his life
savings of 10,000 into a green-grocery business.
Step 1
He opens a business bank account with the 10,000. First of all, what is the dual effect (from
the businesss point of view, remember)?
The business has:
(a)

10,000 cash

(b)

10,000 capital.

Expressed as an equation, this shows:

Net assets =

Capital

Cash

10,000

ie.

Capital

10,000

Net assets = Capital

Step 2
The business buys fruit from Wooster Wholesalers for 4,000, paying cash for it.
Dual effect:

(a)

4,000 of inventories

(b)

4,000 less cash

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Accounting equation:
Net assets =

Capital

Inventories

4,000

Cash

6,000

Capital

________

10,000

10,000

________

10,000
________

________

Again, Net assets = Capital

Step 3
The business buys 2,000 worth of vegetables from Wooster Wholesalers, but this time,
wishing to conserve its cash, arranges to buy them on credit.
Dual effect:
(a)

2,000 more inventories

(b)

A liability or creditor of 2,000

Accounting equation:

Net Assets

Capital

Inventories

6,000

Cash

6,000

Capital

________

10,000

Less

Payables

12,000
(2,000)
________

10,000

________

10,000
________

________

or Net Assets = Capital.

Step 4
The business sells all the fruit for 5,000 cash.
Dual effect:
Is it?
(1)

(a)

5,000 less inventories

(b)

5,000 more cash

(a)

4,000 less inventories

(b)

5,000 more cash

or is it
(2)

The first choice has the merit of obeying the principle set out in paragraph 2.3 above that the
two effects of a transaction are always equal. But unfortunately, if we say that Percy has 5,000
less inventories, this leaves him with only 1,000: and the vegetables, which he still has, cost
2,000.
Whats missing?
He has 4,000 less inventories, 5,000 more cash but the business has made 1,000 profit.
Peter has, of course, made a profit of 1,000 by buying the fruit for 4,000 and selling it for
5,000.
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Inventories
Cash

2,000

Capital

10,000

11,000

Profit

1,000

________

Less

Payables

13,000
(2,000)
________

11,000

________

11,000
________

________

By showing the profit as an addition to capital (as we had to, to make the equation balance), we
have shown what Peter has achieved. Having started off with 10,000 he has added 1,000 to it.
He now has 11,000 invested in the business: from the businesss point of view this is called
capital.
So the summary of the equation is now:
Net Assets = capital.
If Peter customer didnt pay him for the fruit immediately, we would still record the transaction;
but instead of recording 5,000 more cash, we would show it as a receivable. This is still an
asset, since the receivable will (we hope) eventually pay up and the asset receivable will be
converted into cash. Total assets remain the same.
Step 5
A businesss transactions cannot all be simply purchases and sales. It has to pay incidental
expenses such as rent, rates, electricity, telephone and postage.
Suppose Peter pays an electricity bill, in cash, amounting to 200. What is the dual effect?
(a)

200 less cash

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(b)

An expense of 200 which will reduce profit.

Accounting equation:

Inventories
Cash

2,000

Capital

10,800

Profit

10,000
800

________

Less

Payables

12,800 (1,000 200)

(2,000)
________

________

10,800

10,800
________

________

What would the dual effect have been if he had incurred an electricity bill for 200 but
didnt pay it straight away?
(a)

A liability or payable of 200

(b)

200 less profit (as above)

Step 6
Peter buys a Ford van for 4,000 cash. This is an asset which he will keep longer than his
inventories, but it is still an asset, and should not cause you any problem at the moment.
Dual effect:
(a)A van (an asset) of 4,000
(b)4,000 less cash.
Accounting equation:

Van

4,000

Capital
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10,000

Inventories

2,000

Cash

6,800

Less

Payables

Profit

800

________

________

12,800

10,800

(2,000)
________

10,800

________

10,800
________

________

It should normally be clear which items are assets and which are expenses: if in doubt think
whether the item will still be in existence as part of a businesss property at the end of a period
(month, year etc). If it will, its an asset.
Conclusion
The final step reminds us that Peter must gain some personal benefit from the business. He no
longer earns a salary, so in order to feed himself and his family he draws 500 cash out of the
business. The dual effect is the opposite of putting capital in. 500 less cash and 500 drawings
which reduces the capital. Peter final accounting equation at the end of his first month of trading
should now look like this:

Van

4,000 Capital

Inventories

2,000 Profit

Cash

6,300

10,000
800

Less

Payables

________

________

12,300

10,800

(2,000) Less Drawings

________

10,300

________

10,300

________

Assets Liabilities
Or Net Assets

(500)

________

= Capital + Profit Drawings

= Capital at end of period

It is necessary to understand the accounting equation to know and understand the components of
a balance sheet. The accounting equation is simply stated assets liabilities = Shareholder equity
and is necessary to balance the books of a company. The accounting equation is best understood
in the balance sheet. The balance sheet essentially shows how much money the company has,
how much it owes, and what is left for the stockholders. There are many ways that the
accounting equation relates to the components of the balance sheet which can be explained more
in depth. Examples will also provide more in-depth understand of how the components of the
accounting equation affect each other and how transactions affect the accounting equation.

References
accounting Coach. (2013). Retrieved from http://www.accountingcoach.com/online-accountingcourse/14Xpg04.html
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2011). Financial accounting: Tools for business
decision making (6th ed.). Hoboken, NJ: John Wiley & Sons.
McLaney, E., Atrill, P.(2007). Accounting: An Introduction. Financial Times Prentice Hall,
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2008.
University of Phoenix. (2013). Financial Statements. Retrieved from University of Phoenix,
ACC300-Principles of Accounting website.
Warren,C., Reeves, J. (2011). Financial Accounting. Cengage South-Western.

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