Whether you have taken a course in accounting before now, or you are currently taking a course, or you are a full time student of accounting, or you do not know anything about accounting, if you are not able to understand this basic accounting formula or accounting equation, accounting will be as difficult as it has always been for you.
The accounting equation is very important and it is one of the major areas one needs to pay close attention to in the study of accounting and bookkeeping. It is so important that all accounting entries are derived from it. Accounting is made easier if this basic equation or formula is well understood. The totality of financial transactions is based on the accounting equation.
Accounting is based on a fundamental equation called The Accounting Equation or THE Accounting Formula:
ASSETS = CAPITAL + LIABILITIES
It is of utmost importance that your accounting equation balances. If there is a discrepancy in the balance, the financial reports of the company will not be able to help you make sound decisions on the financial position of the company.
The word equation is derived from the word equal. This means one side must be equal to the other.
The above statement can be put in a simple mathematical form as seen below.
Capital is N500,000
Liability is N200,000
Asset must be equal to N500,000 + N200,000 = N700,000
The company pays for these assets by either incurring debts or liabilities or by getting capital from the owner of the business. All the components of the accounting equation appear in the balance sheet, which reveals the financial position of a business at a given time.
With this little description, we can have an overview of what the accounting equation is. So it is now very important to define the key components in the equation.
Assets
Assets are properties of a business. They are owned by the business and they are expected to add value of be of future benefit to the company. Examples of an asset are land and building, furniture, plant and machinery, equipment, motor vehicles, computers, stock, cash and money in the bank. These assets are either brought into the business by the business owner or they are given to the business by outsiders. We have looked at assets in detail in one of our articles.
Capital
This is also called owner’s equity. It is the amount of money or any other asset invested by the owner into the business. It is the owner’s fund or can also be called the net worth of a business.
Liabilities
Liabilities are basically debts. This is the amount owed by the business to outsiders. The amount of liabilities represents the value of the business assets that are owed to others. It is the value of the assets that people outside the business can lay claim to anytime.
In conclusion, the accounting equation simply shows how much of the assets are owned by the owner (capital) and how much of the assets the company owes others (liabilities).