Accounting equation definition

Table of Contents

What is the Accounting Equation? 

An equation that shows the relationship between Assets, Liabilities, and Owner’s Equity is known as the accounting equation. The left side of the equal sign shows the assets and the right side of the equation shows the company’s liabilities. Both sides should be balanced in this equation after recording a transaction.

Assets = Liabilities + Shareholders’ Equity


The resources that are used to generate revenue from a business are assets. If assets are acquired then the left side of the accounting equation increases. Examples of assets include cash, accounts receivable, fixed assets, and inventory. Assets can be paid by incurring liabilities to a third party or by obtaining funds from investors. 


Liabilities are the amount that a business owes to a third party other than the owners of the business. These liabilities are third-party claims over the business. Some examples of liabilities are Accounts payable, Interest payable, Income taxes payable, Bank account overdrafts, Accrued expenses, Short-term loans or the current portion of long-term debt, etc.

Shareholders’ Equity

In a simple sense, Shareholders’ Equity is the money or resources the owners invested in the business. It’s a claim of shareholders over the business. Shareholders’ Equity can be calculated from assets after subtracting the liabilities of the third party. The elaborated form of Owner’s equity is (C+R-E-D).

C = Capital (Increase Owner’s Equity)
R = Revenue (Increase Owner’s Equity)
E = Expenses (Decrease Owner’s Equity)
D = Drawings (Decrease Owner’s Equity)

Limitations of the Accounting Equation

The accounting equation is the framework of the balance sheet. It shows the underlying concept of creating a balance sheet. According to this equation, any transaction can be recorded perfectly even if the transaction is fraudulent.

Example of the Accounting Equation

Analyze the following transactions under the Accounting Equation Approach.
  1. Started business with $200000 cash.
  2. Purchased goods $25000
  3. Paid salary $10000
  4. Sold goods costing $20000 at a profit of 25% on the cost
  5. Paid salary in advance $2000
  6. Introduced additional capital of $10000
  7. Purchased computer for $15000
  8. Deposited $50000 into the bank 

Analyzing the transactions:

  1. If the business started investing cash that will affect the owner’s equity section and also affect the asset section. Both asset (cash) and owner’s equity increase.
  2. Purchasing goods will reduce the cash and also increase assets.
  3. Paying salary will reduce cash (Assets) and also reduce the Owner’s equity as an expense.
  4. Goods sold $20000 so the stock will reduce by $20000. We will receive $25000 (25% of 20000) as cash, So the cash will increase. And we made a profit of $5000 so that will be added to the owner’s equity.
  5. Paying advance salary will create an asset as the labor owes the service to us now. So, it will increase Pre-paid Salary (assets), and also paying cash will decrease our cash balance. So, decrease in cash (assets).
  6. Added to Cash and added to Owner’s equity.
  7. Decrease in cash, increase in the computer as an asset.
  8. Cash decreases and bank balance increases.
You can download the solution.

Sheet Name :- Sheet1

CashStockComputerPre-paid SalaryBankTotalCapitalTotal
2(25000) 47500025000 25000   500000500000 500000
3(10000) 465000   25000      490000(10000) 490000   490000
425000 490000(20000) 5000        4950005000     495000 495000
5(2000) 488000     50002000  2000  495000 495000   495000
610000 498000     5000          2000  505000 505000 505000
7(15000) 483000     5000        15000          2000  505000 505000 505000
8(50000) 433000     5000        15000          2000  50000        505000       505000 505000


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