Accounting equation

Posted in: Introduction to financial accounting (explanations)

By: Rashid Javed | Updated on: December 17th, 2021

Accounting equation describes that the total value of assets of a business entity is always
equal to its liabilities plus owner’s equity. This equation is the foundation of modern double
entry system of accounting being used by small proprietors to large multinational
corporations. Other names used for this equation are balance sheet equation and fundamental
or basic accounting equation.

Definition and explanation

We know that every business holds some properties known as assets. The claims to the assets
owned by a business entity are primarily divided into two types – the claims of creditors and
the claims of owner of the business. In accounting, the claims of creditors are referred to as
liabilities and the claims of owner are referred to as owner’s equity.

Accounting equation is simply an expression of the relationship among assets, liabilities and
owner’s equity in a business. The general form of this equation is presented below:

Assets = Liabilities + Owner’s Equity

Notice that the left hand side (also known as assets side) of the equation shows the resources
owned by the business and the right hand side (also known as equity side) shows the sources
of funds used to acquire these resources. All assets owned by a business are acquired with the
funds supplied either by creditors or by owner. In other words, we can say that the value of
assets in a business is always equal to the sum of the value of liabilities and owner’s equity.
The total dollar amounts of two sides of accounting equation are always equal because they
represent two different views of the same thing.

In accounting equation, the liabilities are normally placed before owner’s equity because
the rights of creditors are always given a priority over the rights of owners. Because of this
preference, the liabilities are sometime transposed to the left side which results in the
following form of accounting equation:

Assets – Liabilities = Owner’s Equity

If dollar amounts of any two of the three elements are known, we can solve the equation to
find the third one. For example, if a business owns total assets amounting to $400,000 and
total liabilities amounting to $120,000, the owners equity must be equal to $280,000 as
computed below:

Assets – Liabilities =  Owner’s Equity

$400,000 – $120,000 = $280,000

Example 1:
Using the concept of accounting equation, compute missing figures from the following:

1. Assets = $100,000, Liabilities = $40,000, Owner’s equity = ?

2. Assets = ?, Liabilities = $20,000, Owner’s equity = $30,000
3. Assets = $120,000, Liabilities = ?, Owner’s equity = $80,000
4. Assets = ?, Liabilities + Owner’s equity = $300,000

Solution

1. Owner’s equity = Assets – Liabilities

= $100,000 – $40,000
= $60,000
2. Assets = Liabilities + Owner’s equity
= $20,000 + $30,000
= $50,000
3. Liabilities = Assets – Owner’s equity
= $120,000 – $80,000
= $40,000
4. The basic accounting equation is: Assets = Liabilities + Owner’s equity. Therefore, If
liabilities plus owner’s equity is equal to $300,000, then the total assets must also be
equal to $300,000.
Impact of transactions on accounting equation
Valid financial transactions always result in a balanced accounting equation which is the
fundamental characteristic of double entry accounting (i.e., every debit has a corresponding
credit).

Every transaction impacts accounting equation in terms of dollar amounts but the equation as
a whole always remains in balance. Any increase in one side is balanced either by a
corresponding decrease in the same side or by a corresponding increase in the other side and
any decrease is balanced either by a corresponding increase in the same side or by a
corresponding decrease in the other side. For better explanation, consider the impact of
twelve transactions included in the following example:

Example 2:

Mr. John started a T-shirts business to be known as “John T-shirts”. He performed following
transactions during the first month of operations:

1. Mr. John invested a capital of $15,000 into his business.

2. Acquired a building for $5,000 cash for business use.
3. Bought furniture for $1,500 cash for business use.
4. Purchased T-shirts from a manufacturer for $3,000 cash.
5. Sold T- shirts for $1,000 cash, the cost of those T-shirts were $700.
6. Purchased T-shirts for $2,000 on credit.
7. Sold T-shirts for $800 on credit, the cost of those shirts were $550.
8. Paid $1,000 cash to his payables.
9. Collected $800 cash from his receivables.
10. The shirts costing $100 were stolen by someone.
11. Mr. John paid $150 cash for telephone bill.
12. Borrowed money amounting to $5,000 from City Bank for business purpose.

Required: Explain how each of the above transactions impacts the accounting equation of
John T-shirts.

Solution

Transaction 1: The investment of capital by John is the first transaction of John T-shirts
which creates very initial accounting equation of the business.  At this point, the cash is the
only asset of business and owner has the sole claim to this asset. Therefore, the equation
would look like the following:

Equation element(s) impacted as a result of transaction 1: “Assets” & “Owner’s equity”.

Transaction 2: The second transaction is the purchase of building which brings two changes.
First, it reduces cash by $5,000 and second, the building valuing $5,000 comes into the
business. In other words, cash amounting to $5,000 is converted into building. The impact of
this transaction on accounting equation is shown below:

Equation element(s) impacted as a result of transaction 2: “Assets”

Transaction 3: The impact of this transaction is similar to that of transaction number 2. Cash
goes out of and furniture comes in to the business. On asset side, The reduction of $1,500 in
cash is balanced by the addition of furniture with a value of $1,500.

Equation element(s) impacted as a result of transaction 3: “Assets”

Transaction 4: The impact of this transaction is similar to transactions 2 and 3. One asset
(i.e, cash) goes out and another asset (i.e, inventory) comes in. The cash would decrease by
$3,000 and at the same time the inventory valuing $3,000 would be recorded on the asset
side.

Equation element(s) impacted as a result of transaction 4: “Assets”

Transaction 5: In this transaction, shirts costing $700 are sold for $1,000 cash. It increases
cash by $1,000 and reduces inventory by $700. The difference of $300 is the profit of the
business that would be added to the capital. The whole impact of this transaction on
accounting equation is shown below:

Equation element(s) impacted as a result of transaction 5: “Assets” & “Owner’s equity”

Transaction 6: In this transaction, T-shirts costing $2,000 are purchased on credit. It
increases inventory on asset side and creates a liability of $2,000 known as accounts payable
(abbreviated as A/C P.A) on the equity side of the equation. Since it is a credit transaction, it
has no impact on cash.

Equation element(s) impacted as a result of transaction 6: “Assets” & “liabilities”

Transaction 7: In this transaction, the business sells T-shirts costing $550 for $800 on credit.
It reduces inventory by $550 and creates a new asset known as accounts receivable
(abbreviated as A/C R.A) valuing $800. The difference of $250 is profit of the business and
would be added to capital under the head owner’s equity.

Equation element(s) impacted as a result of transaction 7: “Assets” & “Owner’s equity”

Transaction 8: In this transaction, business pays cash amounting to $1,000 for a previous
credit purchase. It will reduce cash and accounts payable liability both with $1,000.

Equation element(s) impacted as a result of transaction 8: “Assets” & “Liabilities”

Transaction 9: In this transaction, the business collects cash amounting to $800 for a
previous credit sale. On asset side, it increases cash by $800 and reduces accounts receivable
by the same amount.

Equation element(s) impacted as a result of transaction 9: “Assets”

Transaction 10: The loss of shirts by theft reduces inventory on asset side and capital on
equity side both by $100. All expenses and losses reduce owner’s equity or capital.
Equation element(s) impacted as a result of transaction 10: “Assets” & “Owner’s equity”

Transaction 11: The payment of telephone and electricity bills are business expenses that
reduce cash on asset side and capital on equity side both by $150.

Equation element(s) impacted as a result of transaction 11: “Assets” & “Owner’s equity”

Transaction 12: The loan is a liability because the John T-shirts will have to repay it to the
City Bank. This transaction increases cash by $5,000 on asset side and creates a “bank loan”
liability of $5,000 on equity side.

Equation element(s) impacted as a result of transaction 12: “Assets” & “Liabilities”

In above example, we have observed the impact of twelve different transactions on

accounting equation. Notice that each transaction changes the dollar value of at least one of
the basic elements of equation (i.e., assets, liabilities and owner’s equity) but the equation as
a whole does not lose its balance.
Classification of accounts
Posted in: Introduction to financial accounting (explanations)
By: Rashid Javed | Updated on: December 14th, 2021

In accounting, the accounts are classified using one of two approaches – modern approach
or traditional approach. We shall describe modern approach first because this approach of
classification of accounts is used in almost every advanced country. The use of traditional
approach is very limited and it will be discussed later.

Modern approach
According to modern approach, the accounts are classified as asset accounts, liability
accounts, capital or owner’s equity accounts, withdrawal accounts, revenue/income accounts
and expense accounts.

1. Asset accounts:

Assets are things or items of value owned by a business and are usually divided into tangible
or intangible. Tangible assets are physical items such as building, machinery, inventories,
receivables, cash, prepaid expenses and advance payments to other parties. Intangible assets
normally include non-physical items and rights. Examples of intangible assets include
goodwill, trademarks, copyrights, patent rights and brand recognition etc.

A separate ledger account for each tangible and intangible asset is maintained by the business
to record any increase or decrease in that asset.

2. Liability accounts:

Liabilities are obligations or debts payable to outsiders or creditors. The title of a liability
account usually ends with the word “payable”. Examples include accounts payable, bills
payable, wages payable, interest payable, rent payable and loan payable etc. Besides these,
any revenue received in advance is also a liability of the business and is known as unearned
revenue. For example, a marketing firm may receive marketing fee from its client for the
forthcoming quarter in advance. Such unearned revenue would be recorded as a liability as
long as the related marketing services against it are not provided to the client who has made
the advance payment.

3. Capital or owner’s equity accounts:

Capital is the owner’s claim against the assets of the business and is equal to total assets less
all liabilities to external parties. The balance in capital account increases with the
introduction of new capital and profits earned by the business and decreases as a result of
withdrawals and losses sustained by the business.
In sole proprietorship, a single capital account titled as owner’s capital account or simply
capital account is used. In partnership or firm, each partner has a separate capital account like
John’s capital account, Peter’s capital account etc. In corporate form of business there are
many owners known as stockholders or shareholders and the title capital stock account is
used to record any change in the capital.

4. Withdrawal accounts:

Withdrawals are cash or assets taken by a business owner for his personal use. In sole
proprietorship and partnership, an account titled as drawings account is used to account for
all withdrawals. In corporate form of business withdrawals are more systematic and usually
termed as distributions to stockholders. The account used for recording such distributions is
known as dividend account.

5. Revenue or income accounts:

Revenue is the inflow of cash as a result of primary activities such as provision of services or
sale of goods. The term income usually refers to the net profit of the business derived by
deducting all expenses from revenue generated during a particular period of time. However,
in accounting and finance, the term is also used to denote all inflows of cash resulted by those
activities that are not primary revenue generating activities of the business. For example, a
merchandising company may have some investment in an oil company. Any dividend
received from oil company would be termed as dividend income rather than dividend
revenue. Other examples of income include interest income, rent income and
commission income etc. The businesses usually maintain separate accounts for revenues and
all incomes earned by them.

6. Expense accounts:

Any resource expended or service consumed to generate revenue is known as expense.

Examples of expenses include salaries expense, rent expense, wages expense, supplies
expense, electricity expense, telephone expense, depreciation expense and miscellaneous
expense.

Traditional approach
According to traditional approach, the accounts are classified into four types – personal
accounts, real accounts, nominal accounts, and valuation accounts. A brief explanation of
each is given below:

1. Personal accounts:

The accounts related to real persons and organizations are classified as personal accounts.
Examples of personal accounts include John’s account, Peter’s account, Procter and
Gamble’s account, Vibrant Marketing Agency’s account and City bank’s account etc. The
business keeps a separate account for each individual and organization for the purpose of
ascertaining the balance due from or due to them.

2. Real accounts:
Real accounts are accounts related to assets or properties (both tangible and intangible)
owned by a business enterprise. A separate account for each asset is maintained to account
for increases and decreases in that asset. Examples of real accounts include cash account,
inventory account, investment account, plant account, building account, goodwill account,
patent account, copyright account etc.

3. Nominal accounts:

The accounts related to incomes, gains, expenses and losses are classified as nominal
accounts. These accounts normally serve the purpose of accumulating data needed for
preparing income statement or profit and loss account of the business for a particular period.
Examples of nominal accounts include sales account, purchases account, wages account,
salaries account, interest account, rent account, gain on sale of fixed assets account and loss
on sale of fixed assets account etc.

4. Valuation account:

Valuation account (also known as contra account) is an account which is used to report the
carrying value of an asset or liability in the balance sheet. A popular example of valuation
account is the accumulated depreciation account. Companies maintaining fixed assets in the
books of accounts at their original cost also maintain an accumulated depreciation account for
each fixed asset. In balance sheet, the balance in the accumulated depreciation account is
deducted from the original cost of the asset to report it at its book value or carrying value.
Another example of valuation account is allowance for doubtful accounts. In balance sheet,
the balance in allowance for doubtful accounts is deducted from the total receivables to report
them at their net realizable value or carrying value.

ADVERTISEMENT

Example
From the following transactions identify the accounts involved and classify them according to
modern and traditional approaches of classification of accounts:

1. Mr. John started business with cash $25,000

2. Purchased goods for cash $5,000
3. Sold goods for cash $7,500
4. Purchased goods for cash $2,500
5. Sold goods to Sam on account $3,000
6. Purchased furniture for $1,000
7. Purchased machinery for $5,000
8. Paid wages $200
9. Mr. John withdrew $100 from business to pay his personal expenses.

Solution:
» Classified Balance Sheet
Definition of Classified Balance Sheet
A classified balance sheet is a type of balance sheet presented so that the sub-components of
assets, liabilities, and equity are presented so that the readers get a better understanding of the
items of the financial statements. The broader headings are broken down into simpler, smaller
headings for better readability of the annual accounts.

Explanation

The financial statements shall be prepared in such a manner that they provide a true and fair
view of the business’s financial affairs to the users of the statement. To achieve this
objective, the financial statements are usually prepared in such a manner that each of the
broad headings of assets, liabilities, and equity is further classified into a number of
meaningful sub-headings.

The management has to decide what type of classification it wants to apply to the headings
since there are no set of subcategories that have been prescribed, nor there is any limit on the
number of sub-headings that are to be created under each heading. However, it is important to
first classify the assets and liabilities and current and non-current as a bare minimum. Further,
accounting standards may prescribe minimum reporting line items.
Objectives of Classified Balance Sheet

Classified balance sheets are prepared to meet the following objectives:

 Make the analysis and understanding of financial statements easier.

 Understand the nature of assets, liabilities, and equity in the company’s financial
statements.
 Determine the company’s liquidity position by understanding the level of current
assets available to meet the current liabilities.
 Make it easier to compare the changes in liabilities and assets from the last reporting
year.

Classification of Classified Balance Sheet

Some of the widely used classifications for balance sheet components are as below:

Assets

1. Property, plant and, equipment

2. Trade and other receivables
3. Cash and cash equivalents
4. Financial assets
5. Inventories

Liabilities

1. Trade and other payables

2. Provisions
3. Financial liabilities
4. Borrowings
5. Employee benefit liabilities

Equity

1. Issued capital
2. Reserves

Further assets and liabilities are to be classified as long-term and short-term on an item to
item basis based on whether those items are expected to be realized (in case of assets) or
settled (in case of liabilities) within a period of twelve months after the reporting period.
Accounting standards may provide for additional conditions too for classification of items as
non-current and current such as for current-assets IAS-1 states that an item that is primarily
held for trading purposes shall be classified as non-current.
Example of Classified Balance Sheet

Here is how a classified balance sheet normally looks.

Balance Sheet as At 31.12.2020

(Amounts expressed in hundreds of dollars currency units)

Year Ended
Particulars Notes
31.12.2020 31.12.2019
Assets
Non-Current Assets
Goodwill                7,419                     5,902
Other intangible assets              25,972                   19,995
Property, plant and equipment              56,606                   23,422
Investments accounted for using the equity method.                   947                         799
Investment property              12,754                   12,509
Other long-term assets                   126                         102
Other long-term financial assets                4,104                     3,917
Total Non-Current Assets 107,796 66,514
Inventories              32,422                   29,627
Prepayments and other short-term assets                   225                         233
Trade and other receivables              28,429                   22,319
Derivative financial instruments                   695                         835
Cash and cash equivalents                   711                         673
Other current assets              42,561                     9,819
Assets included in a disposal group classified as held
                    22                     3,258
for sale.
Total Current Assets 104,933 66,632
Total Assets 212,707 133,124
Equity
Equity attributable to owners of the parent:
Share capital              15,842                   12,292
Share premium              40,067                     4,487
Other components of equity                   602                         742
Retained earnings              61,082                   42,193
Equity attributable to owners of the parent           117,527                   59,648
Non-controlling interest                   802                         670
Total equity 118,307 60,296
Liabilities
Non-Current Liabilities
Pension and other employee obligations              12,353                   11,978
Borrowings              51,940                   25,953
Trade and other payables                1,360                           22
Deferred tax liabilities                1,381                         902
Other liabilities                1,876                     2,079
Total Non-Current Liabilities 68,822 40,846
Current Liabilities
Provisions                   637                     2,302
Pension and other employee obligations                1,647                     1,420
Borrowings                6,530                     5,185
Trade and other payables              10,574                   18,827
Current tax liabilities                3,035                         837
Contract and other liabilities                3,309                     3,182
Liabilities included in a disposal group classified as
                    22                         405
held for sale.
Total Current Liabilities 25,622 32,026
Total Liabilities 94,422 72,850
Total Equity and Liabilities 212,707 133,124