The accounting equation (Assets = Liabilities + Equity) tells us that the balance sheet is balanced by definition, as all assets will be financed either by the owners themselves (equity) or by other people (liabilities).
Since assets are presented on the debit side of the balance sheet and liabilities and equity on the credit side, the accounting equation implies the fundamental equation in accounting that total debits should equal total credits at all times.
It is important to know that the accounting process is governed by accounting principles that sometimes are very binding and sometimes provide some flexibility. Well known principles include International Financial Reporting Standards (IFRS) and U.S. GAAP (Generally Accepted Accounting Principles).
Sometimes economic assets are not allowed to be recognized as accounting assets by accounting principles. In other words: some assets may not be on the balance sheet. This generally is the case when it is difficult to determine the value of the asset.
Further reading: Additional reading on accounting principles.
In general, application of accounting principles results in the situation where the book value of assets (and equity) is below the market value of assets (and equity), since book assets are usually understated. This difference is expressed by the market-to-book ratio (dividing the market value of equity by the book value of equity).
Further reading: Additional reading on the market-to-book ratio.
Using the Accounting Equation to Record Transactions
The method to record transactions described in this section is based on the accounting equation. Hence, it only keeps track of items on the balance sheet.
This method is extended in the next lesson double entry bookkeeping, where also changes over time are recorded.
The accounting equation for transactions
The accounting equation states that all assets are funded by either the owners (equity) or others (liabilities):
Assets = Liabilities + Equity.
The accounting equation refers to the balance sheet, where assets are shown on the debit side and the funding (liabilities and equity) on the credit side. If the accounting equation holds for the balance sheet at a point in time, it must hold for the beginning of period balance sheet as well as the end of period balance sheet. It then logically follows the accounting equation must also hold for changes; i.e., for each transaction the change in assets must equal the change in liabilities plus the change in equity: ΔAssets = ΔLiabilities + ΔEquity.
Accounting Equation Example
Example transactions for newly incorporated firm ABCD Inc. which offers services for garden design and landscaping. For each transaction the accounting equation is shown.
Jan 1: The firm is incorporated on the 1st of January, 20X0. The owner, Betty, pays 40,000 cash for 10,000 shares.
Following the accounting equation, cash (an asset) will increase by 40,000, as well as paid in capital (equity) increases by 40,000.
Jan 2: ABCD Inc. buys a Grasshopper lawn mower for 8,000 cash.
Cash (assets) decreases with 8,000, while equipment (assets) increases by the same amount. The net change in assets is therefore 0.
Jan 10: ABCD Inc. pays 500 cash for advertising in the local newspaper.
Cash (an asset) will decreases with 500, and retained earnings (equity) decreases with 500.
Jan 15: ABCD Inc receives 3,000 cash for services delivered in January.
Cash (an asset) and retained earnings (equity) increase with 3,000.
Jan 26: ABCD joins the Association of Landscapers, and receives an invoice of 400 to be payable in February.
Accounts payable (liability) increases with 400, and retained earnings (equity) decreases with 400.
|Accounts payable||Retained earnings|
Jan 31: The company pays a 1,000 cash dividend.
Cash (an asset) and retained earnings (equity) decreases with 1,000.