The accounting equation

A simple representation of the statement of financial position

The accounting equation is a simplified way of showing a statement of financial position. The equation is:

Formula: Accounting equation

Assets = Equity + Liabilities

A        = E        + L

Each new financial transaction affects the numbers in the accounting equation, but the accounting equation must always apply. Total assets must always be equal to the combined total of equity plus liabilities.

The accounting equation is a useful introduction to the preparation of a simple statement of comprehensive income and statement of financial position. It is also a useful introduction to the principles of double-entry book-keeping, and the duality concept that every transaction has two aspects that must be recorded.

The accounting equation and the business entity concept

The use of the accounting equation is based on the business entity concept, that a business is a separate entity from the person or persons who own it. The owner puts capital into the business, and the business ‘owes’ this to the owner.

Illustration:

Farid sets up a business ‘Farid’s Security Services’ and puts some capital into the business.

The accounting system of the business would consider that ‘Farid’s Security

Services’ is an entity on its own, separate from Farid, and that Farid is an owner to which the business owes the capital.

Using the accounting equation

The accounting equation is:

Formula: Accounting equation

Assets = Liabilities + Equity or Assets - Liabilities = Equity

A        = L             + E             A        - L             = E

Assets minus liabilities is usually called net assets.

A change on one side of an equation must be matched by a change on the other.

Therefore, an increase in net assets means a matching increase in equity capital and a fall in net assets means a matching fall in equity capital.

Movements in equity are caused by:

·         profit being added to capital or losses deducted from capital; and

·         the introduction of more capital into the business (perhaps by providing it with additional cash or other assets);

·         payments to the owners in the form of drawings (or dividends in the case of a company).

In other words, net assets will change in value between the beginning and end of a financial year by the amount of profit (or loss) in the period, new capital introduced and drawings or dividends taken out.

Illustration:

                                                      Rs.

Opening equity/net assets (ONA)    X

Profit (P)                                         X

Capital introduced (CI)                    X

Drawings (D)                                 (X)

                                                           

Closing equity/net assets (CAN)       X

The value of any term can be calculated if the others are known.