Definition, Components and Examples of Accounting Basic Equations

Nowadays, the field of Accounting is becoming a popular field of work and department. If you are an Accountant or a student who is in the period of accounting studies must understand what is the basic element of Accounting, namely the Basic Accounting Equation. The Basic Accounting Equation is a relationship between debt, assets, and capital of a company because each business transaction affects at least two company accounts.

Accounting is the measurement, elaboration, and provision of certainty about information that will help investors, managers, tax authorities or other decision makers to make the allocation of decision resources within organizations, companies, and government agencies.

Basic Accounting Equations: Fundamental Elements of Accounting

The Basic Accounting Equation is the foundation for all accounting systems. In fact, all accounting concepts and frameworks are based on the basic accounting equation. The basic accounting equation equates a company’s assets with its liabilities and equity. This shows that all of the company’s assets are obtained from funding from debt or equity. For example when a new company is built, the first asset purchased comes from funds received from investors or from loans (debt). Thus all company assets that come from creditors or investors are called liabilities and equity. If described by the formula, the formulation is as follows:

Assets = Liabilities + Equity

As you can see, the asset side is equivalent to the number of liabilities and owner’s equity. This makes sense if the mindset is liability and equity is basically just a source of funding for companies to buy assets.

This equation is generally written with the position of the liability placed before the owner’s equity. Because debts to creditors must be paid off before investors when the company goes bankrupt. In other words, liabilities are considered more current or liquid than equity. This is proven to be consistent with the example of financial reporting where current assets (Current Assets) and current liabilities (Current Liabilities) are always reported before fixed assets (PPE) and long-term liabilities (Long-Term Debt).

This equation applies to all business activities and transactions. Assets will always be equivalent to liabilities and owner’s equity. If assets increase, both liabilities or owner’s equity must increase to balance the equation. Vice versa, if assets decline, liabilities and owner’s equity also decline.

Components in the Basic Accounting Equation

Now that we have a basic understanding of the equation, let’s look at each component of the accounting equation that starts with assets.

1. Assets

Assets are resources that are owned or controlled by a company for future use. Some assets are tangible such as cash and some are intangible or intangible such as goodwill or copyright. Here are some examples of asset accounts:

  • Current assets: Cash, Receivables, Prepaid Expenses.
  • Fixed Assets: Vehicles, Buildings.
  • Intangible Assets: Goodwill, Copyright, Patents

2. Obligations or liabilities

Obligations or commonly referred to as liabilities are a number of funds that the company borrows from other parties (creditors) and must be paid in accordance with the agreed time. A common form of obligation is debt. Debt is the opposite of receivables. When a company buys goods or services from another company on credit, debt is recorded to show that the company promises to pay later. Here are a few examples of the most common liability accounts.

  • Short-term Debt: Trade Debt, Bank Debt, Salary Debt, Tax Debt.
  • Long-term Debt: Bond Debt

3. Equity

Equity is part of company assets owned by shareholders or third parties. Owners can increase their share of ownership by investing funds in the company or reducing equity by withdrawing company funds (prive). Likewise, income increases the equity side while costs decrease equity. Some general equity accounts such as Owner’s Capital, Owner’s Withdrawal (prive), Retained Earnings, Common Stock, Paid-in Capital.

Also read:  Understanding Basic Accounting for Beginners, What Are They?

Example of Basic Accounting Equations

Gus is a businessman who wants to start a company that sells musical instruments. After saving money for a year, Gus decided to officially start his business. He formed Guitars, Inc . and invested IDR 100,000,000 in his new company. This business transaction increases the company’s cash and increases equity by the same amount.

Basic Equation of Accounting
Asset The obligation Equity
Cash Owner’s capital
100,000,000 100,000,000
Assets = Liabilities + Equity

 

After the formation of the company, Guitars, Inc . need to buy some guitar inventory which will then be resold for a total of Rp. 80,000,000. In this case, Guitars, Inc . use cash to buy assets in the form of inventory, so the cash account decreases and the inventory account increases.

Basic Equation of Accounting
Asset The obligation Equity
Cash Stock Owner’s capital
IDR 20,000,000 IDR 80,000,000 Rp 100,000,000
Assets = Liabilities + Equity

 

After six months, Guitars, Inc . growing rapidly and need to find a new business place. Gus decided that the most sensible thing for Guitars, Inc . to buy a building. Because Guitars, Inc . do not have Rp. 500,000,000 cash to pay for the building, the company must take a loan. Guitars, Inc . bought a building for Rp.500,000,000 by paying Rp10,000,000 in cash and borrowing from the bank the remaining Rp.490,000,000. This business transaction reduced cash by Rp10,000,000, increased assets in the form of buildings by Rp500,000,000 and increased liabilities with a bank loan of Rp.490,000,000.

Basic Equation of Accounting
Asset The obligation Equity
Cash Stock Building Bank Loans Owner’s Capital
10,000,000 80,000,000 500,000,000 490,000,000 100,000,000
Assets = Liabilities + Equity

 

Following is an example of the fundamental application of the Basic Accounting Equation. As you can see, the value of assets is always balanced by the amount of liabilities and equity.

 

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