Accounting equation

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Basic accounting equation is the foundation for the double-entry book-keeping system.

Contents

1 The equation
2 Re-write
3 How it works
4 Balance sheet

The equation

The equation is as follows:

[Assets=Liabilities+Shareholders'\ Equity]

It shows how assets were financed: either by borrowing money from someone else (liability) or by paying your own money (shareholder's equity). For example, a student buys a computer for $945. This student borrowed $500 from his best friend and saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.

Re-write

If formula is re-written in this manner:

[Assets-Liabilities=Shareholder's\ Equity]

Now it shows that owner's interest is equal to property (assets) minus debts (liabilities). Since in a company owners are shareholders, owner's interest is called shareholder's equity.

How it works

Every accounting transaction affects at least one element of the equation but always balances. Simplest transactions also include:

Transaction    Assets        = Liabilities + Shareholder's equity
1.         + 6.000                         +6.000
2.         +10.000          +10.000
3.         +   900  -900
4.         + 1.000  -450    +   550
5.         +   700                         +  700
6.         -   200                         -  200
7.                          +   100        -  100
8.         -   500          -   500
9.         +   200   -200

Explanation of transactions:

issuing stocks for cash or other assets;
buying assets by borrowing money (taking a loan from a bank or simply buying on credit);
buying assets for cash (in essence, it's just an exchange of one asset to another);
buying assets by paying cash and by borrowing money;
earning revenues;
paying expenses (e.g., rent or professional fees) or dividends;
recording expenses, but not paying them at the moment;
paying on a debt that you owe;
received cash for sale of an asset

These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.

Balance sheet

An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity and makes sure it balances (thus the name of balance sheet).

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