The accounting equation is one of the fundamental principles that guide how business transactions are recorded and reported. Although it is a simple formula, the application is as wide as accounting is concerned. From posting to ledger's to the preparation of financial statements, the accounting equation is applicable.
Defining Accounting Equation
Accounting equation is defined as the equation that equates the totals of equity and liabilities to that of assets. The formula for the equation is as follows:
- Equity + Liabilities = Assets
Assets are the property of a business. In a more broader term, assets are resources of an entity that is capable of generating cash flow whether actively or passively. Examples are property, plants, and equipment.
Liabilities are claims by individuals, groups of individuals, and organizations that are external to a business. Creditors remain a primary example for liabilities.
Equity is the residual value after deducting liabilities from assets. It is seen as the funds used to start a business. For small businesses such as a sole trader and partnership, equity is referred to as capital.
Application of accounting equation
We can apply the accounting equation when posting to ledger accounts and in the preparation of the statement of financial position.
When posting to the ledger
Business transactions occur on a daily basis, and as a result, they affect equity, liabilities, and assets. Their effect can be increasing their value or reducing it. For example, if expenses are paid in cash, it literally reduces the relevant assets account (cash) and equity.
Here are examples of business transactions and their impact on the accounting equation
1. Start a business with N1.2 million
This will increase Equity and Assets by N1.2 million.
2. Purchase goods on credit for resale N700,000
Increase Liabilities and increase Assets with N700,000
3. Paid for goods purchased earlier
Reduce Liabilities and Assets with N700,000
4. Sold goods on credit for N640,000
It will increase Assets (debtors) and reduce assets (inventory) by N640,000. It will also increase Equity in terms of profit earned.
When preparing Statement of Financial Position (SOFP)
The SOFP applied the accounting equation. The statement must have equal balance. However, this depends on how it is prepared. It can be in any of the two ways:
- Assets - Liabilities = Equity
- Assets = Equity + Liabilities
Conclusion
The accounting equation is a useful principle to all accountants. It helps in understanding ledger accounts and also prepares the balance sheet of an entity. The equation can be written in two ways. In both ways, it is expected that the two sides of the equation balance.
