Accounting Equation: Definition, Formula & Examples

income statement

Owners/shareholders can invest by contributing cash or some other asset. Assets are the available resources that your company can use to produce positive economic value. Is a factor in almost every aspect of your business accounting.

  • We are not permitted to carry out regulated business activities.
  • It would be cumbersome to record each revenue/expense, gain/loss transaction directly into the retained earnings account.
  • There are two ways a business can finance the purchase of assets.
  • The accounting equation emphasizes a basic idea in business; that is, businesses need assets in order to operate.
  • Notice each account subcategory has an “increase” side and a “decrease” side.

After all, it is the foundation for double- accounting. The accounting equation will help you accurately read your company’s balance sheet and understand the financial statements of your business. You must record your business transactions in accordance with the accounting equation so each part of your journal entry is correct. Each entry that you make on the debit side should have a corresponding entry on the credit side. For this reason, you must implement proper bookkeeping and auditing practices. This equation should be supported by the information on a company’s balance sheet. The Accounting Equation is the foundation of double-entry accounting because it displays that all assets are financed by borrowing money or paying with the money of the business’s shareholders.

Income Statement

Both inflows and outflows are included within each category. Revenues are the inflows of cash resulting from the sale of products or the rendering of services to customers. We measure revenues by the prices agreed on in the exchanges in which a business delivers goods or renders services. Now that you have a better understanding of the language of financial statements, let’s look at Metro Courier’s financial information and prepare some financial statements. X purchases new equipment worth $2,000 which decreases its assets and increases its assets. Examples include purchases made for material, payment of rent, expenses for employee costs.


As long as an organization follows the accounting equation, it can report any type of transaction, even if it is fraudulent. Accounts payable include all goods and services billed to the company by suppliers that have not yet been paid.

Financial and Managerial Accounting

Instead, they are a component of the’s equity account, placing it on the right side of the accounting equation. Another component of shareholders’ equity is the business’s earnings.

What is the main purpose of accounting equation?

The accounting equation represents the relationship between the assets, liabilities and capital of a business and it is fundamental to the application of double entry bookkeeping where every transaction has a dual effect on the financial statements.

In each instance, the receives something in exchange for something else . The sum of the debits must equal the sum of the credits for each transaction. Answers will vary but may include vehicles, clothing, electronics (include cell phones and computer/gaming systems), and sports equipment.

The Accounting Equation:

It gives meaning to the balance sheet structure and is the foundation of double-entry accounting. Double-entry accounting is the practice where one transaction affects both sides of the accounting equation. This is used extensively in journal entries, where an increase or decrease on one side of the equation may be explained by an increase or decrease on the other side.


Unearned revenue is a liability to the entity until the revenue is earned. Learn the concept of unearned revenue, also known as deferred revenue. Gain an understanding of business scenarios in which organizations need to park their receipts as unearned. Look at some real-life examples and understand the accounting treatment for unearned revenue.

1 Defining the Accounting Equation Components

One side of each account will increase, and the other side will decrease. The ending account balance is found by calculating the difference between debits and credits for each account. You will often see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr, respectively. Depending on the account type, the sides that increase and decrease may vary. We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded equation (see Figure 4.4). The statement of cash flows presents the effects on cash of all significant operating, investing, and financing activities. By reviewing the statement, management can see the effects of its past major policy decisions in quantitative form.

How do you calculate accounting equation?

In straightforward terms, the accounting equation states that assets always equal liability plus equity. That’s how you will build a balance sheet, a critical financial document showing a company’s current snapshot in a given period. The balance sheet and the income and cash flow statements represent the three fundamental financial statements that any company should be able to monitor to be financially viable.

A business can now use this equation to analyze transactions in more detail. We begin with the left side of the equation, the assets, and work toward the right side of the equation to liabilities and equity. In order to make sure that the accounts of a company are balanced, the total assets must equal the sum of the total of all liabilities and owner’s equity. To see if everything is balanced, the totals are simply plugged in to the accounting equation. Once the math is done, if one side is equal to the other, then the accounts are balanced. On January 1, 2020, the business had $100,000 assets in terms of cash, $0 liabilities, and $100,000 owner’s equity. The contributed capital , beginning of retained earnings , and dividends show the company’s transactions with the shareholders.

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