Accounting Equation Overview, Formula, and Examples

For example, let’s say the balance of your bank accounts, plus your other assets (like computers, furniture, etc.) and your accounts receivable total $15,000. This is the “assets” portion of the balance sheet, or the entire top portion of it. On your balance sheet, these three components will show how your business is financially operating. Your assets include your valuable resources, while your liabilities include any debts or obligations you owe.

  1. Merely learning these formulas is less likely to be effective in dealing with numerical that are included under this topic.
  2. This implies the cash will be debited for $36,840 and revenue credited for $36,840.
  3. For example, an increase in an asset account can be matched by an equal increase to a related liability or shareholder’s equity account such that the accounting equation stays in balance.
  4. Merely placing an order for goods is not a recordable transaction because no exchange has taken place.
  5. Such transactions may also be posted directly to the general ledger.

Also, the statement of retained earnings allows owners to analyse net income after accounting for dividend payouts. All basic accounting formulas discussed throughout this post highlight the importance of double-entry bookkeeping. For a company keeping accurate accounts, every business transaction will be represented in at least two of its accounts. For instance, if a business takes a loan from a bank, the borrowed money will be reflected in its balance sheet as both an increase in the company’s assets and an increase in its loan liability. The accounting equation is also called the basic accounting equation or the balance sheet equation. In this form, it is easier to highlight the relationship between shareholder’s equity and debt (liabilities).

The accounting equation is based on the premise that the sum of a company’s assets is equal to its total liabilities and shareholders’ equity. As a core concept in modern accounting, this provides the basis for keeping a company’s books balanced across a given accounting cycle. For example, Blooms & Co. company generates revenue of $5,000 at the end of the fiscal year. The company’s accounting cycle will include recording all the transactions, journal entries, general ledger, trial balances, reviewing & fixing errors, creating financial statements, and closing. This makes our list of important how to write a voided check for direct deposits because once you understand it, you can see at a glance how healthy your business is.


The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left side value of the equation will always match the right side value. The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet. It can be defined as the total number of dollars that a company would have left if it liquidated all of its assets and paid off all of its liabilities.

If not, then there is an error somewhere in the underlying transactions (an unbalanced entry) that should be corrected before proceeding. In most accounting software systems, it is impossible to have transactions that do not result in matching debit and credit totals. Record in the appropriate accounts in the accounting database the amounts noted on the business document. This may involve recording transactions in a specific journal, such as the cash receipts journal, cash disbursements journal, or sales journal, which are later posted to the general ledger. Such transactions may also be posted directly to the general ledger.

What Is a Real-World Example of the Accounting Equation?

It’s the accountants’ responsibilities to keep an accurate journal of these transactions. Every transaction’s impact to Assets must have either offsetting impact to Assets or matching impact to Liabilities and Equity. Anushka will record revenue (income) of $400 for the sale made.

Let us take the example of an equipment purchase that has been funded by a mix of available cash and bank loan. The subject company has bought a piece of equipment worth $10.5 million that has been funded by cash of $3.5 million and a bank loan of $7.0 million. Knowing how to calculate retained earnings helps business owners to perform a more in-depth financial analysis. Also, the statement of retained earnings allows owners to analyze net income after accounting for dividend payouts.

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And increasing your gross profit margin has a direct impact on your net income. Increasing your gross profit margin by decreasing cost of sales lets you grow your business’ profitability without increasing sales. Now, let’s say, of your $5,000 in liabilities, $2,000 is current. Accounts payable, credit card balances and short-term lines of credit are all current liabilities.

Step 6: Prepare Post-Closing Trial Balance

Current assets and liabilities can be converted into cash within one year. The CFS shows money going into (cash inflow) and out of (cash outflow) a business; furthermore, the CFS is separated into operating, investing, and financing activities. Metro Corporation collected a total of $5,000 on account from clients who owned money for services previously billed. During the month of February, Metro Corporation earned a total of $50,000 in revenue from clients who paid cash.

The company is significantly big in size and operations; thus, they have an accounting cycle. Let’s create and analyze the step-by-step process of the accounting cycle for the company. Alternatively, the budget cycle relates to future operating performance and planning for future transactions. The accounting cycle assists in producing information for external users, while the budget cycle is mainly used for internal management purposes. The accounting cycle focuses on historical events and ensures that incurred financial transactions are reported correctly. To know more about accounting activities and their formulas in calculating those, look into our online learning programmes for a clear understanding.

This is the total of all debts you owe — credit cards, lines of credit, accounts payable, etc. A high debt-to-equity ratio illustrates that a high proportion of your company’s financing comes from issuing debt, rather than issuing inventory to shareholders. Suppose you’re attempting to secure more financing or looking for investors. In that case, a high debt-to-equity ratio might make it more difficult to find creditors or investors willing to provide funds for your company. It’s important to note that although dividends reduce retained earnings, they are not expenses. Therefore, dividends are excluded when determining net income (revenue – expenses), just like stockholder investments (common and preferred).

They were acquired by borrowing money from lenders, receiving cash from owners and shareholders or offering goods or services. The accounting equation will always be “in balance”, meaning the left side (debit) of its balance sheet should always equal the right side (credit). If a business buys raw materials and pays in cash, it will result in an increase in the company’s inventory (an asset) while reducing cash capital (another asset). Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting.

An accounting transaction is a business activity or event that causes a measurable change in the accounting equation. Merely placing an order for goods is not a recordable transaction because no exchange has taken place. In the coming sections, you will learn more about the different kinds of financial statements accountants generate for businesses.

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