Basic Accounting Equation

Understanding the basic accounting equation is essential in learning and doing

the accounting process. This equation is often used in the accounting procedures, from
recording until interpretation of the financial data.

What is the Basic Accounting Equation?

Basic Accounting Equation states that the business resources (assets) are attributable to the
amount owed to creditors (liabilities) and capital invested by the owners (equity). It is
formulated as follows:

ASSET = LIABILITY + EQUITY

Asset
Pertains to the resources available and used in sustaining the operation of the business. It
includes cash, accounts receivable, inventory, office supplies, equipment, building, land,
goodwill, patent, etc.
Liability
Refers to the amount of debts owed to outside person or entity, known as creditors. It
represents the claim of creditors in the assets of the business. It includes accounts payable,
loans payable, notes payable, bonds payable, unearned revenue, etc.
Equity
Is the amount of capital or resources invested in the business by the owner(s). It represents
the claim of owners in the assets of the business. It consist of capital, drawing, common
stock, additional paid in capital, preferred stock, retained earnings, net income, net loss.

Rules on Basic Accounting Equation

1. Both side of the Basic Accounting Equation should be equal and
balance.
Example:
The business, XYZ Company, has total assets amounting to $1,000,
amount of debt and capital totaling $250 and $750, respectively.
Asset = Liability + Equity
$1,000 = $250 + $750
$1,000 = $1,000
Note: Total amounts on both sides are equal.
2. For every valid business transaction recorded should affect or
change two accounts. It means that in every value received,
another value is given up. This is also referred to as double-entry
recording.
Look at the following instances:

a.

Increase in asset account should have an equivalent increase in

liability or equity account. As shown in Example 1 and 2.

Example # 1:
Joe Smith, sole proprietor of XYZ Company, invested cash amounting to
$10,000 to start and operate his accounting software company.
Asset = Liability + Equity
Cash $10,000 = 0 + $10,000 J.Smith, Capital
Note: The cash invested affected two accounts which are cash
(asset) and capital (equity) account.
Example # 2:
XYZ Company was granted a bank loan from ABC Bank amounting to
$4,000.

Asset = Liability + Equity

Cash $4,000 = $4,000 Loans Payable + 0
Note: The cash loan received from bank affected two accounts
which are cash (asset) and loans payable (liability) account.

b.

Decrease in asset account should have an equivalent decrease in

liability or equity account. As shown in Example 3 and 4.

Example # 3:
Joe Smith withdraws cash amounting to $500 from the business for his
personal use.
Asset = Liability + Equity
Cash ($500) = 0 + ($500) J.Smith, Capital
Note: The cash withdrawal of Joe indicates that it was used for
personal purposes, as such, it is considered as capital withdrawal.
Parenthesis () represents decrease in amount or value.
Example # 4:
XYZ Company paid in cash the partial amount of its loan to ABC Bank
amounting to $2,500.
Asset = Liability + Equity
Cash ($2,500) = ($2,500) Loans Payable + 0
Note: The amount of cash paid to ABC Bank represents payment
of bank loans. As such, there will be an equivalent decrease on
both cash (asset) and loans payable (liability) account.

c.

Increase or decrease may affect two accounts on one side of the

equation. As shown in Example # 5.

Example #5:
XYZ Company purchased office supplies amounting to $250 paid on cash.

Asset = Liability + Equity

Cash ($250) = 0 + 0
Office Supplies $250 = 0 + 0
Note: The example affected both asset accounts. Cash decreased
by $250 while office supplies increased by $250.