What is Accounting Equation? Example, Procedure of Forming

  • Post last modified:22 February 2022
  • Reading time:16 mins read

The accounting equation lays a foundation for the double-entry accounting system. The equation balances the company’s balance sheet, which means the total of the assets equals to the total of the liabilities and shareholders’ equity.

The double-entry accounting system means each entry made on the debit side has a corresponding entry on the credit side. In other words, every transaction has a debit effect equal to the credit effect. When every transaction is correctly balanced, the overall accounting equation automatically balances

What is Accounting Equation?

The accounting equation shows the assets of the business to which creditors have a claim as the business promises them a payment in exchange for their goods or services taken. In the case of loans taken from banks or any other individual, creditors need interest on the investment made by them and their principal amount after the due period. The accounting equation is written as:

Assets = Liabilities + Equity

The accounts will balance only if all transactions are recorded correctly with the double-entry effect (which ensures that nothing is eliminated). Nowadays, with computerised accounting, every transaction made automatically creates a double effect and the balance sheet is generated and the status is shown on a daily basis. Let us understand the concept of the accounting equation with the help of examples.

Accounting Equation Example

Example 1: If cash of ₹5,000 is deposited in a bank, the cash balance will reduce by 5,000 and the bank balance will increase by ₹5,000.

Therefore, an accountant’s job is to keep close track of the claims on the company’s assets that arise from various business events and transactions. The process of analysing transactions and events means using the accounting equation Assets = Liabilities + Equity. This can happen only if the double-entry system is followed accurately. An accountant has to determine the items that are affected by the transaction or event and record it in the books of accounts.

Example 2: If a business has assets of value ₹100000 and has creditors of ₹30,000, the owners after selling the assets for 100000 settle the creditors of 30,000 and get a claim to ₹70,000

Assets = Liabilities + Equity

₹ 100000 = ₹ 30000 + ₹ 70000

Example 3: If the assets are worth ₹ 120000 and the creditors are worth ₹ 25000. Find the equity.

Assets = Liabilities + Equity

₹ 120000 = ₹ 25000 + Equity

Equity = ₹ 120000 ₹ 25000

Equity = ₹ 95000


Procedure of Forming Accounting Equation

To form accounting equations for different types of events, you need to follow a specific process. The effect of transactions on assets, liabilities and equity would be different but they need to equate each other. You will see each case one by one.

Equity

Equity does not mean only equity shares it can be capital invested by the entrepreneur in the business. Hence, the definition needs to be modified. Equity shares can be issued by a company on the formation of a business and during the life of the business.

The main purpose of issuing equity shares is to raise funds for different reasons such as expanding business, introducing new technology, etc. Equity issued at the start of the business is the capital and is shown on the liability side of the balance sheet, as it is a liability to be given to the owners on the closure of the business.

On the other hand, as the investment comes in cash in hand or bank, the same amount appears on the assets side.

Thus, equating both the amounts on the balance sheet. However, when there is a subsequent issue of shares for the purpose of business expansion, the ownership gets diluted as the same amount of equity is now distributed over a large number of shareholders.

Example: Elephant Ltd., a one person company, issued its equity shares to Mr. Atul amounting to ₹ 20 lacs and received the amount in its bank account. Therefore, you can see that Mr. Atul is the sole owner of Elephant Ltd. as he owns all the stock. However, Mr. Atul and Elephant Ltd. are two separate entities and Elephant Ltd. has a separate bank account where the amount of equity is deposited. Therefore, the transaction is that Elephant Ltd. issued shares at a value of ₹ 20 lacs.

Assets = Liabilities + Equity

Cash received in bank ₹ 20 lacs

Equity of ₹ 20 lacs

When analysing this transaction, you must ask the following questions:

  1. Is an exchange for money or moneys value done?
    Ans: Yes, money was received in the account of Elephant Ltd


  2. How was cash affected by the transaction?
    Ans: There can be only two effects: cash increases or cash decreases. In this transaction, the cash increases. According to the dualaspect concept of accounting, the transaction is recorded when cash is received in the bank and the second transaction is recorded for the capital received.


  3. What is the exchange for the cash received?
    Ans: In return of the cash received, the business gave its sole ownership.


  4. What is the effect on the equity?
    Ans: There is an increase in the amount of equity.

    Assets = Liabilities + Equity

    Cash = Liabilities + Equity

    ₹ 20 lacs = Liabilities + ₹ 20 lacs

In this way, as the events or transactions go on increasing, the accounting equation also expands. And you can analyse the business status. Hence, to arrive at the accounting equation, you must always ask the abovementioned questions starting from whether cash is involved and how it is affected.

The next question is what is given in exchange of the cash and similarly the transaction is affected. Most transactions involve the exchange of money and give us a good starting point to analyse and form the equation.

Purchase of office equipment or machinery

A new business uses its initial capital to purchase the new office setup, equipment and machinery required for the core business. The business can also invest on these assets subsequently when expanding its business operations or volume of production. All purchases are done in exchange of cash.

Example: Continuing with the above example, Elephant Ltd. purchases office equipment worth ₹ 3 lacs. What process would you follow to record this transaction? Consider the questions mentioned in the previous example.

Assets = Liabilities + Equity

Cash paid ₹ 3 lacs

Machinery/equipment of ₹ 3 lacs

  1. Is an exchange for money or moneys value done?
    Ans: Yes, money was paid from Elephant Ltd.’s account.


  2. How was cash affected by the transaction?
    Ans: There can be only two effects: cash increases or cash decreases. In this transaction, the cash decreases. According to the doubleentry accounting system, the first entry is recorded when cash is paid from the bank and the second entry is recorded for the machinery/equipment received.


  3. What is the exchange for the cash paid?
    Ans: In return of the cash paid, the business received the machinery required for production.


  4. What is the effect on the office production?
    Ans: There is an increase in the amounts of assets and production.

    Assets = Liabilities + Equity

    Other Assets + Cash = Liabilities + Equity

    Machinery (₹ 3 Lacs) + Cash (₹ 17 Lacs) = Liabilities (0) + Equity (₹ 20 Lacs)

Here, you can see that cash decreases and assets increase. Both the effects are on the same side of the equation. However, there is a change in the individual accounts.

Receiving advance payments

In this kind of transaction, services or goods are not delivered but the payment is received. Cash is received against a promise for delivering goods or services at a future date. In the case of nonfulfilment of this promise, the cash must be paid back which means it is a liability to the business.

Example: Continuing with the same example, Elephant Ltd. receives an advance payment of ₹2 lacs from its clients in cash which it deposits in its bank and shows them as Deposits/Advance Received.

Assets = Liabilities + Equity

Cash received ₹2 lacs

Deposit/advance ₹2 lacs

How do you record this event so that the accounting equation balances off? You start with the same process of asking questions which will give us the final answer.

  1. Is an exchange for money or moneys value done?
    Ans: Yes, money was received in Elephant Ltd.’s account.


  2. How was cash affected by the transaction?
    Ans: In this transaction, cash increases.


  3. What is the exchange for the cash received?
    Ans: In return of the cash received, the business promises to deliver its goods or services at a future date.


  4. What is the effect on the business?
    There is a sure business in the future. However, if the promise is not fulfilled, it needs to pay the money back, which is a liability and is not earned by the business yet.

Assets = Liabilities + Equity

Other Assets + Cash = Liabilities + Equity

Machinery (₹ 3 Lacs) + Cash (₹ 19 Lacs) = Liabilities (₹ 2 Lacs) + Equity (₹ 20 Lacs)

In the above transaction, cash increases making the assets side ₹ 22 lacs and on the liability side is recorded for 2 lacs bringing it to ₹ 22 lacs.

Credit sales

When there are credit sales, goods or services are already delivered but the cash is not received. How can this transaction be recorded?

Example: Elephant Ltd. sold its goods worth ₹ 1 lac to Sam on credit, the credit period being 3 months.

Assets = Liabilities + Equity

Goods sold worth ₹ 1 lac

Receivable amount of ₹ 1 lac in three months.

Following the same process of questioning, you get the accounting equation:

Assets = Liabilities + Equity

Other Assets + Cash = Liabilities + Equity

Machinery (₹ 3 lacs) + Cash (₹ 19 lacs) + Receivable (₹ 1 lac) Goods (₹ 1 lac) = Liabilities (₹ 2 lacs) + Equity (₹ 20 lacs)

Both the transactions affect the same side as the receivables increase and goods worth decreases bringing the value of both the sides equal.

Therefore, now you can see that for every event there is an effect on cash and if cash is not involved, receivable or payable accounts are affected. Some major balancing elements are given below in the broad categories of assets, liabilities and equity:

Assets = Liabilities + Equity

(Cash, supplies, shares, equipment, loans, receivables, earnings and inventory) = (Payables, bills payables, tax payable and advance/ deposits) + (Equity shares, preference shares, debentures, loans and retained earnings)

Retained earnings

Retained earnings are the third way by which a company raises its funds. Retained earnings, as the name suggests, refers to the revenue a business reserves for future expansion projects where funds would be required.

These reserves can be created by eliminating some expenses or reducing them or by not issuing all profits by the way of dividends, putting some part of it aside into retained earnings. Therefore, in short, the source of Retained Earnings is from Revenue, Expenses and Dividends which in short is called (RED).

Hence, if retained earnings increase, the dividend payout decreases and revenue declared for dividend decreases and cash would increase and decrease at the same level, thus balancing the accounting equation.

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