The Accounting Equation looks at the relationship between a business’ assets, its liabilities and its capital.
The Accounting Equation
The accounting equation tells us that the value of a business’ assets is the same as the total of its liabilities and capital. The diagram below shows this equation written in three different ways.
Assets are resources of the businesses such as money in its bank account, money owed to it by customers, inventories and property, plant and equipment
Liabilities are the amounts the business owes to its suppliers, lenders, employees, government and so on
Capital is the amount the owners of the business have tied up in the business. It consists of the money that the owner invested in the business plus any profits made by the business less any amounts drawn out of the business by its owners.
Illustrations of the accounting equation
Let’s say that an accountant, Delilah starts a business and pays £5,000 as capital into the business’ bank account. This payment will increase the business’ bank balance (an asset) by £5,000 and will also increase the business’ capital by £5,000. In terms of the accounting equation this transaction could be described as follows:
Delilah then purchased some computer equipment for £2,500 and paid for this using a bank loan. The business’ assets have therefore risen by £2,500 and its liabilities has gone up by the same amount. This transaction will have the following effects on the business’ assets, liabilities and capital
Next, Delilah completes some work for a client and issues an invoice for £800. This has created a debt due to the business (an asset) of £800 and has also increased the business’ capital by £800. [It increases the business’ capital as sales increase profits and profits form part of the business’ capital]. The effect on the business’ assets, liabilities and capital is as follows:
Next, Delilah pays £2,000 from the business’ bank account to her landlord for office rent. This will reduce the bank balance (an asset) by £2,000 and will also decrease the business’ capital by £2,000. [It will reduce the business’ capital as this is an expense and expenses reduce business profits]. The effect of the transaction will be:
Finally, Delilah transfers £1,000 from the business bank account to a business savings deposit account. This transaction will reduce the value of its bank account (an asset) by £1,000 and at the same increase the value of another asset, the savings deposit account by £1,000; its effect will be:
Uses of the accounting equation
The accounting equation was vital in the development of double-entry bookkeeping. It highlights the fact that all transactions have at least two distinct effects; that if a business has an asset, the cost of the asset must have been funded somehow. Thus, when an amount is recorded on the debit side of a General Ledger account there must be a corresponding entry on the credit side of a General Ledger account.
The accounting equation is also often used where an accountant is dealing with incomplete records (i.e. some parts of a business’ books are missing).
In addition, HR Revenue & Customs may use the equation when they investigate an individual’s tax affairs. If a person’s assets have risen significantly HMRC may review whether the increase can be explained by the person’s income over the period and by changes in their person’s liabilities. If not, it is evidence that the person might have undeclared income.