Question

What is the accounting equation? Briefly explain each of the three parts and why it is important that they are set up as an equation. Support your explanation with examples of how the three parts of the accounting equation impact an organization's transactions.

Answer 1

Accounting Equation

Accounting equation shows the relationship between the assets and liabilities of a business. It is based on double entry system of accounting. The basic accounting equation is :

Assets = Liabilities + Stockholders equity

Assets represents the economic resources owned by a business. Assets can be tangible or intangible.Examples of assets are building,plant ,cash ,inventories,etc...

Liabilities are the financial obligation or the debts of a business. Examples of liabilities are accounts payable,taxes payable,loans ,overdraft,etc..

Stockholders equity is the owner's claims on assets of the business. Some examples are owner's equity, preferred stock ,retained earnings,etc...

Both liabilities and shareholders's equity represents how assets of a company are financed.

Example 1:

If the asset of the company is $ 60000 and liability is $20000, then what is the owner's equity?

Assets = Liabilities + Stockholders equity

Therefore, owner's equity =Assets-Liabilities

= $60000-$20000

=$40000

The accounting equation impact organization transactions because when a transaction occurs in an organization , atleast two accounts are affected. For example , consider a transaction-

Commenced business with cash,$50000

In the above transaction cash is increased in the asset side .Also capital is increased by $50000.Therefore 2 accounts are affected on both asset and liability side.

The relationship between assets and liabilities are shown as an equation to understand how the changes in one account affects the othe account.

Accounting equation is important because:

1. It is an important tool for investors and lenders to access the company 's financial situation.

2. For ensuring that debit and credit are recorded accurately.

Thus , we can conclude that accounting equation forms the basis for all accounting transactions. The financial statements are prepared on this basis.