In a double-entry system, for every debit entry there must be a credit entry and vice versa. This leads us to the basic accounting equation:
Assets = Liabilities + Owners’ Equity
The above equation shows how assets are financed: either by borrowing money from someone (liabilities) or by paying your own money (owner’s equity).
The accounting equation holds at all time over the life of the business. When a transaction occurs, the three components, asset, liability, and equity, may change, but the equation will remain in balance.
Let’s look at an example.
In the first day when John started his business John’s Shoeshine Corp, John invested $10,000 to exchange for 100 common shares of his company. The $10,000 was deposited in the bank account of the company. At the end of the day, the asset of the company is $10,000, liability is $0, and the owners’ equity is also $10,000. The equation holds.
After a few days, John borrowed $5,000 from his brother, Mike, to buy a shoe shining machine for $5,000. The assets were increased (debit) by $5,000 to $15,000 with the addition of the machine. Liabilities were also increased (credit) by $5,000 (the loan from Mike) and the owners’ equity stayed unchanged at $10,000. The equation holds.
Because owners’ equity is composed of capital contributions, retained earnings, dividends, revenues, and expenses, the basic accounting equation can be expanded as:
Assets = Liabilities + Capital contribution (stock) + retained earnings – Dividends + Revenues – Expenses.
Like the basic accounting equation, the expanded equation must balance at all time.
For example, the next day, John did shoe shining service for a customer for $500. The customer paid cash. After the transaction:
Asset = $10,000 (cash in bank) + $5,000 (machine) + $500 (cash from the customer) = $15,500
Liabilities = $5,000 (loan from Mike)
Retained Earnings = 0
Revenues = $500
Expenses = 0
Plug the numbers into the equation:
$15,500 = $5,000 + $10,000 + 0 – 0 + $500 – 0
The equation holds.
The accounting equation is the fundamental building block of accounting. A clear understanding of the accounting equation is essential to post transactions in a double entry accounting systems. It is also helpful for reading and utilizing financial reports such as a balance sheet.