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Accounting Equation
Definition, Meaning Explained, Usage

 

The accounting equation summarizes the essential nature of double entry accounting systems: Debits always equal Credits, and Assets always equal the sum of Equities and Liabilities.

The Balance Sheet Always Balances.

What Are the Two "Accounting Equations?"

The term Accounting Equation, in fact, refers to two equations that are basic and central in accrual accounting and double entry accounting systems.

The term "Accounting Equation" has meaning only in accrual accounting. It does not apply in cash-based, single entry accounting.

The Accounting Equation, in fact, provides two basic rules that distinguish accrual accounting from cash basis accounting, and single entry systems from double entry systems.

  • The first of these equations is the Basic Accounting Equation: Assets=Liabilities+Equities.
  • The term Expanded Accounting Equation refers to the Basic Equation together with the second equation: Debits=Credits.

Explaining the Accounting Equation in Context

Sections below further explain collateral in context with lending-related terms including:

Balance Sheet
Assets
Liabilities
Owners Equities
Accrual Accounting
Debits
Credits
Journal
Ledger
 

Contents

Related Concepts

 

The Balance Sheet Always Balances
The Basic Accounting Equation

Firstly, the Basic Accounting Equation is another name for the Balance Sheet Equation, a simple summary of Balance sheet properties:

Assets = Liabilities + Owners Equities

The three elements of this equation Assets, Liabilities, and Owner's equities are the three major sections of the Balance sheet. Through the use of double entry bookkeeping, bookkeepers and accountants ensure that the "balance" always holds (both sides of the equation are always equal). 

Example: Maintaining the Balance

Consider a purchase by a retail merchant, Woofer Pet Supplies. On 2 September, Woofer purchases pet food merchandise inventory from its supplier, Ajax Wholesale Feed Company. Ajax charges Woofer $1,180 for the order. Woofer does not pay Ajax immediately, however. Consequently, Ajax gives Woofer an invoice marked "Payable" for that amount. Woofer's bookkeeper or accountant, therefore, makes two journal entries for the purchase:

  • Woofer creates a new "account payable" and adds (credits) its value to Accounts payable. Note especially that Accounts payable is a liabilities account, and therefore its balance increases with a credit transaction.
  • The second entry required in a double-entry system is a simultaneous debit to the asset account, Merchandise Inventory. Asset account balances increase with a debit transaction.

Exhibit 1 below shows how these transactions appear in the buyer's journal.

Woofer Pet Supplies
Journal for Fiscal Year 20YY
Date Account Debit
Credit
2-Sep-20YY
2-Sep-20YY
 103  Merchandise Inventory
 200      Accounts payable
$1,180  
$1,180

Exhibit 1. The buyer purchases merchandise inventory on credit, making two journal entries. Firstly, the buyer debits (increases) Merchandise Inventory, a Current assets account. Secondly, the buyer credits (increases) a Current liabilities account, Accounts payable.

The Merchandise inventory account is on the Assets side of the Balance sheet, while Accounts Payable is on the "Liabilities + Equities" side. Adding the same $1,180 to each side, of course, maintains the accounting equation balance

Now note that on 5 September, Woofer pays the amount due Ajax, using a debit card transaction to Ajax for $1,180. Double entry accounting requires that Woofer's accountant or bookkeeper make two more entries in the accounting system journal simultaneously:

  • Woofer decreases (debits) the Accounts Payable account balance FOR $1,180
  • Woofer decreases (credits) one of its Current Assets accounts, Cash, for the same amount, $1,180. (Note that accountants treat the debit card transaction as a cash transaction).
Woofer Pet Supplies
Journal for Fiscal Year 20YY
Date Account Debit
Credit
5-Sep-20YY
5-Sep-20YY
 200  Accounts payable
 150      Cash
$1,180  
$1,180

Exhibit 2. The buyer pays cash to cover a debt to the seller with two transactions. Firstly, the buyer debits (decreases) accounts payable, because the debt is now settled, and secondly, the buyer credits (decreases cash) for the amount of the payment. These two decreases occur on different sides of the Balance sheet, maintaining the balance.

Again, the Accounting Equation Balance holds.

Total Debits Always Equal Total Credits
Accounting Equation Second Meaning

The term Expanded Accounting Equation represents an extension of the "Basic Equation" to include another fundamental rule that applies to every accounting transaction wherever firms use double-entry bookkeeping::

Debits = Credits

The equation summarizes one result of using making double-entry debits and credits correctly.

  • Firstly, Debit-Credit equality must hold for every event that impacts accounts. The Journal entries in Exhibits 1, 2, and 3 illustrate this equality. Every transaction brings a credit entry in one "account" and an equal, offsetting debit entry in another.
  • Secondly, across any specified timespan, the sum of all debit entries must equal the total of all credit entries. System-wide debit-credit equality must hold, given the same balance applies for every pair of "entries" that follows a transaction.

Accounting Equation 2, in fact, serves to provide an essential form of built-in error checking for accountants using a double entry system. Near the end of each accounting period, a short timespan covers the so-called "trial balance period." At this time, accountants summarize the period's debits and credits for all active accounts in the general ledger. A mismatch between debit and credit totals in this trial balance usually means that one or more transaction postings from "journal" to "ledger" are either in error or missing.

See the article Trial Balance for more on the use of Accounting Equation 2 for error checking during the trial balance period.

Example: Total Debits Equal Total Credits

Note, by the way, that the two offsetting entries that follow a single transaction do not need to occur on opposite sides of the Balance sheet. For example, a cash flow transaction to purchase an asset brings a "credit" to one asset account, "Cash on hand" (a credit decreases an asset account) and an equal, offsetting "debit" to another asset account, perhaps "merchandise inventory" (a debit increases an asset account).

Exhibit 3, below shows how such transactions can appear in the buyer's journal. In this case (Exhibit 3), Woofer Pet Supplies buys pet food inventory with a cash payment made immediately with the order.

Woofer Pet Supplies
Journal for Fiscal Year 20YY
Date Account Debit
Credit
30-Sep-20YY
30-Sep-20YY
 103  Merchandise Inventory
 150      Cash
$2,400  
$2,400

Exhibit 3. The buyer purchases the merchandise inventory with cash and makes two journal entries. Firstly, the buyer debits (increases) Merchandise Inventory, a Current assets account. Secondly, the buyer credits (decreases) the Cash account, another Current asset account.

The Merchandise inventory account is on the Assets side of the Balance sheet, and Cash is $2,400 from another Assets account maintains "Balance Sheet balance" and the Debits = Credits equality.

Example Balance Sheet Structure and Contents
Detailed Example

The Balance sheet stands as a detailed representation of the Accounting Equation:

Assets = Liabilities + Equities.

Exhibit 4 illustrates the equation with a detailed example Balance sheet.

Grande Corporation                                   Figures in $1,000's
Balance Sheet at 31 December 20YY   
ASSETS
Current Assets
   Cash
   Short-term investments
   Accounts Receivable
      Less allowance doubtful accts
      Net accounts receivable
   Notes receivable short-term
   Inventories
      Raw materials
      Work in progress
      Finished goods/merchandise
      Operating & office supplies
            Total Inventories
   Prepaid exp, insurance, def taxes
          Total Current Assets




1,969
   137



    611
1,692
3,664
      19


1,369
  137


1,832
     20





5,986
  265
















9,609
Long-Term Investments and Funds
   Common stock held
   Preferred stock held
   Bonds Held / Sinking funds
   Other Long-Term Investments
          Total Long-Term Investments
    
  493
  184
  364
  419





1,460
Property, Plant & Equipment
   Factory Manufacturing Equipment
      Less accumulated depreciation
      Net factory mfr equipment
   Store Equip / Selling Assets
      Less accumulated depreciation
      Net store/selling equipment
   Computer systems
      Less accumulated depreciation
      Net computer systems
           Total Property, Plant & Equip
 
5,983
 2,782

5,456
 1,292

4,721
 2,370




3,201

4,164


  2,351










9,716
Intangible Assets
   Copyrights
   Trademarks and Patents
   Goodwill
          Total Intangible Assets
    
1,014
108
  100




1,222
Other Assets
                    Total Assets
         68
22,075
LIABILITIES
Current Liabilities
   Accounts payable
   Notes payable, short-term
   Current portion of long-term debt
   Accrued expenses, Interest payable
   Unearned revenues
   Taxes payable Other withholding
          Total Current Liabilities



 1,642
    912
    349
     146
     274
    141








3,464
Long-Term Liabilities
   Bank notes payable
   Bonds payable, other LT liabilities
          Total Long-Term Liabilities
                    Total Liabilities
     
912
 4,562



 5,474
8938
OWNERS EQUITY
Contributed Capital
   Preferred stock
   Common stock
   Contributed capital excess of par
          Total Contributed Capital

Retained Earnings
          Total Owners Equity


3,798
4,184
 1,457





9,439

 3,698








13,137
          Total Liabilities and Equities
    22,075
 

Exhibit 4. A detailed example Balance sheet, representing the Accounting Equation: Assets = Liabilities + Equities.