It is important to have a basic know-how about the financial concepts when starting a business. Whether you are launching a tech startup that is using cutting-edge technologies like Machine Learning (ML), Artificial Intelligence (AI), etc. or working on a non-technical business idea, the fundamentals of business accounting remain the same. Owner’s Equity, Assets, and Liabilities are the three basic concepts related to financial accounting. The equation that connects all these three dots is called Accounting Equation.
What is Accounting Equation
Accounting Equation represents the relationship between Assets, Liabilities, and Owner’s Equity. It is the foundation of the double-entry principle. As per the double-entry principle, total debits equates to total credits for any type of financial transaction.
The expression of accounting equation which is most commonly used for the preparation of financial statements is:
Assets = Owner’s (Stockholder’s) Equity + Liabilities
Core Components of Accounting Equation
Let’s look into the core components that form the basis of the Accounting Equation:
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Assets
Assets are the resources that have economic value or can create economic value. Liquid cash is considered a special form of asset. Assets like patents, copyrights, etc. are considered as intangible assets and assets like inventory, vehicles, cash, equipment, etc. are considered as tangible assets.
Assets = (Liabilities + Owner’s Equity)
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Liabilities
Liabilities are the payments that your business needs to make. Some of the prime examples of liabilities are lease payments, payments on the lines of credit, loan payments, etc. It could be either short-term liability or long-term liability. Short-term liabilities are the business liabilities that are due within the next one year whereas long-term liabilities are the business liabilities that are due after one year from the current date.
Liabilities = (Assets – Owner’s Equity)
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Equity held by the Owner (Stockholder)
Owner’s Equity is different from the value of the business. It refers to the percentage of the business that belongs to you.
Stockholder’s Equity = (Assets – Liabilities)
Accounting Equation in Practice
For demonstrating the usage of the Accounting Equation, let us take a hypothetical business scenario where:
Mr. Bizman, a sole proprietor has the following transactions in account books for 2019:
- Jan 1 Invested Capital of 20,000 INR.
- Jan 2 Purchased goods on credit from Marks & Co. for 2,000 INR.
- Jan 4 Bought machinery for 8,000 INR on cash.
- Jan 8 Purchased goods for 4,000 INR on cash.
- Jan 12 Sold goods for (cost of inventory 4,000 + profit 2,000) 6,000 INR on cash
- Jan 18 Paid to Marks & Co. in cash 1,000 INR
- Jan 22 Received 300 INR from Mr. Deb (being a debtor)
- Jan 25 Paid salary of 6,000 INR
- Jan 30 Received interest of 5,000 INR
- Jan 31 Paid wages of 3,000 INR
The effect of above transactions on Liabilities, Assets, and owner’s equity are shown below:
| Date | Transactions | Assets = | Liabilities + | Owner’s Equity (Capital) |
| 01.01.19 | Capital brought into the business 20,000 | 20,000 | – | 20,000 |
| 02.01.19 | Purchased goods on credit from Marks & Co., 2,000 | + 2000 | + 2,000 | – |
| Revised equation | 22,000 = | 2000 + | 20,000 | |
| 04.01.19 | Bought machinery for cash 8,000 | +8,000 -8,000 |
– – | – – |
| Revised equation | 22,000 = | 2000 + | 20,000 | |
| 08.01.19 | Purchased goods for cash 4000 | +4,000 -4,000 |
– – | – – |
| Revised equation | 22,000 = | 2000 + | 20,000 | |
| 12.01.19 | Sold goods for cash (cost of inventory 4,000 + Profit 2,000) 6000 | +6,000 -4,000 |
– – | +2,000 |
| Revised equation | 24,000 = | 2000 + | 22,000 | |
| 18.01.19 | Paid to Marks and Co., in cash 1,000 | -1,000 | -1,000 | – |
| Revised equation | 23,000 = | 1000 + | 22,000 | |
| 22.01.19 | Received from Mr. Deb 300 (being a debtor) | -300 +300 |
– – | – – |
| Revised equation | 23,000 = | 1000 + | 22,000 | |
| 25.01.19 | Paid salary 6,000 | -6,000 | – | -6,000 |
| Revised equation | 17,000 = | 1000 + | 16,000 | |
| 30.01.19 | Received interest 5,000 | +5,000 | – | + 5,000 |
| Revised equation | 22,000 = | 1000 + | 21,000 | |
| 31.01.19 | Paid wages 3,000 | -3,000 | – | -3,000 |
| Revised equation | 19,000 = | 1000 + | 18,000 |
Accounting Methods
To keep a track of the financial transactions, it is necessary to follow an accounting method. Accounting method means that a timely financial record is created when income is accrued/ received or expenses are incurred/ paid.
Based on the scale and target customer segment of the business, you can choose from any of the three accounting methods:
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Cash Accounting Method
As the name signifies, a transaction is recorded when money changes hands. Businesses where payment by customers is predominantly in cash make use of this accounting method.
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Accrual Accounting Method
It is the most widely used accounting method. As per the accrual accounting method, gross income should be reported the moment it is earned. This means that record creation is not dependent on when the actual cash flow associated with the transaction occurs.
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Hybrid Accounting Method
It is a combination of the Cash accounting method and the Accrual accounting method.
Conclusion
Accounting Equations can be one of the most important tools to access the financial health of the business. If your company has more liabilities than assets, you should rethink the way you manage your money!
