Accounting equation

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The basic accounting equation is the foundation for the double-entry book-keeping system.

1 The equation
2 Re-write
3 How it works
4 Balance sheet
5 External links

[edit] The equation

The equation is as follows:

Assets = Liabilities + Shareholders equity

It shows how assets were financed: either by borrowing money from someone else (liability) or by paying your own money (shareholder's equity). For example, a student buys a computer for $945. This student borrowed $500 from his best friend and saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.

[edit] Re-write

If formula is re-written in this manner:

Assets - Liabilities = Owners equity

Now it shows that owner's interest is equal to property (assets) minus debts (liabilities). Since in a company owners are shareholders, owner's interest is called shareholder's equity.

[edit] How it works

Every accounting transaction affects at least one element of the equation, but always balances. Simplest transactions also include:

Transaction                                      Shareholders'
   Number         Assets      =  Liabilities  +     equity
-----------    -------------     -----------     -------------
     1.        + 6,000                              +6,000
     2.        +10,000             +10,000
     3.        +   900  -900
     4.        + 1,000  -450       +   550
     5.        +   700                              +  700
     6.        -   200                              -  200
     7.                            +   100          -  100
     8.        -   500             -   500
     9.        +   200  -200

Explanation of transactions:

issuing stocks for cash or other assets;
buying assets by borrowing money (taking a loan from a bank or simply buying on credit);
buying assets for cash (in essence, it's just an exchange of one asset to another);
buying assets by paying cash and by borrowing money;
earning revenues;
paying expenses (e.g., rent or professional fees) or dividends;
recording expenses, but not paying them at the moment;
paying on a debt that you owe;
received cash for sale of an asset

These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.

[edit] Balance sheet

An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity and makes sure it balances (thus the name of balance sheet).