Fundamental Accounting Equation
Accounting is a vital aspect of companies in all sectors, and is essential to control and track the expenses and income of organizations.
People with an interest in mathematics may want to pursue a career in accounting, which requires an understanding of a variety of formulas and equations.
The fundamental accounting equation, in particular, is an important aspect of a company’s accounting system, making it essential for accountants to understand it.
Liabilities + equity = assets
In this article, we discuss the fundamental accounting equation and its elements and provide examples to help you better understand this concept.
What is fundamental accounting?
Fundamental accounting uses an equation to explain the relationship between the funds used to purchase a company’s assets and the value of those assets to estimate the value of the company.
This style of accounting focuses on the double-entry system of keeping an organization’s books, as the total debits for each transaction are equal to the total credits.
Using this method ensures that the equation stays balanced on both sides.
Following the fundamental accounting method, a company must include each of its transactions in at least two of its accounts.
For example, if an organization were to borrow from a bank, the borrowed funds would increase both total assets and total liabilities.
If that same organization purchased raw materials with company funds, that transaction would increase total assets and reduce liabilities as well.
Fundamental Accounting Equation
Liabilities + equity = assets
Also called the balance sheet equation, the fundamental accounting equation is the double-entry accounting system.
In calculating the fundamental accounting equation, an accountant must review the balance sheet, which must include:
- Total assets
- Total responsibilities
- Shareholders’ equity
The sum of liabilities and equity must be equal to the amount of total assets.
For example, if a company reports $120 million of liabilities in the third quarter of the current fiscal year, plus $40 million of equity, the underlying accounting equation would determine that the company has $160 million of total assets.
There is also an expanded version of the fundamental accounting equation, which shows a more detailed breakdown of the equity component of the standard equation:
Liabilities + income + contributed capital – dividends – expenses = assets
Elements of the fundamental accounting equation
In the fundamental accounting equation, there are three main components:
- Liabilities: Liabilities are the financial debts or obligations of the business, including accounts payable, deferred revenue, and promissory notes. Short-term and long-term debts also fall into the category of liabilities.
- Equity: Equity refers to the participation of the shareholders of the company, that is, the percentage of the company that they own. It includes the contributions and withdrawals of the owners, income and expenses, as well as retained earnings and capital stock.
- Assets: Assets include all equipment owned by the business, as well as cash, certificates of deposit, treasury bills, inventory, prepaid expenses, and accounts receivable. Assets also include rights and items acquired through quantifiable transactions. A company may borrow or build assets, or shareholders may contribute assets to the company.
If a company goes bankrupt or goes out of business, it will sell its assets and use the funds to settle all liabilities.
The remaining funds would go to shareholders, although all debts must be paid before shareholders are entitled to the company’s assets and their value.
What is the fundamental accounting equation for?
The fundamental accounting equation helps capture the relationship between several key components of a company’s balance sheet.
These components are equity, assets, and liabilities. All other things being equal, a company’s net worth increases when assets increase and decreases when assets are sold or lost.
Paying off debt reduces a company’s liabilities, and the equation represents the change in assets as a result.
This equation is also important to modern accounting, as each ledger entry must take into account where it fits into the equation and how it affects the assets and liabilities of the business.
When managing a company’s books, an accountant typically uses two columns: one for debits and one for credits.
Each transaction has a complementary transaction in the other column, ensuring that the total debits equal the total credits according to the equation.
Examples of the fundamental accounting equation
Regardless of the complexity of a company and its financial details, the fundamental accounting equation can be applied.
These examples range from the simplest to the most complex, giving you a better idea of the application of this equation and how it can benefit an accountant’s accounting system:
Juan wants to buy a laptop to use at school. He has $400 in cash and his father is willing to lend him $500. The cost of the laptop is $900. Applying the fundamental accounting equation, Juan would include the $900 in the computer as an asset, the $400 in cash as a decrease in the asset column, and the $500 as an increase in liabilities.
$900 (assets) = $500 (liabilities) + $400 (equity)
Robloc Oil has $350,000 in assets with $150,000 in total liabilities and $200,000 in equity. Applying the fundamental accounting equation, total assets are equal to the sum of liabilities and stockholders’ equity.
$350,000 (assets) = $150,000 (liabilities) + $200,000 (equity)
Amy starts Amy’s Design Service as a sole proprietorship, putting $10,000 of her money into the business. She took out a $5,000 loan to buy the equipment she needed for the company and to advertise the services she offered. The business now has $15,000 in assets, reflecting the $10,000 she invested and the $5,000 she borrowed.
$15,000 (assets) = $10,000 (equity) + $5,000 (liabilities)
Metropolitan Courier Service issued shares of the company to investors at $5 each, offering 10,000 shares to interested parties. Investors bought all the available shares, which brought $50,000 into the company’s bank account. The company also has $15,000 worth of delivery vehicles in its fleet, which were purchased with funds borrowed from a financial institution.
$65,000 (assets) = $50,000 (equity) + $15,000 (liabilities)