Accounting Equation
In this lesson, we will learn how to group the accounting terms into clear categories like assets, liabilities, equity, incomes and expenses. You will see how these groups are connected and work together to form the Accounting Equation. By understanding these links, you’ll be able to see how business transactions affect a company’s financial position.
Related Lessons:
Identifying Accounting Groups
Before we learn to apply the accounting equation, let us learn what the accounting groupings are and the accounts that falls under each of these groupings.
Assets
Are resources that a business owns and use to carry out its operation.
Examples of accounts: Trade receivables, inventory, cash in hand, cash at bank, machinery, equipment, fixtures & fittings, motor vehicles, premises, buildings
Liability
Are obligations that a business owes to others.
Examples of accounts: Trade payables, loans
Capital
Are assets contributed by the business owner into the business.
Examples of accounts: Capital
Drawings
Are business assets withdrawn by business owner for personal use.
Examples of accounts: Drawing
Income
Are revenue earned by the business.
Examples of accounts: Sales revenue, discount received, interest income, commission income etc
Expense
Are goods or services used by the business to earn income.
Examples of accounts: Cost of sales, sales returns, discount allowed, utilities, rent, salaries etc
Applying Accounting Equation
Each account group is linked by the Accounting Equation:
Assets = Liability + Owner’s Equity
where Owner’s equity = Capital + Profit for the year (or minus Loss for the year) – Drawings
Profit or Loss for the year = Income – Expenses
As such, the accounting equation can also be written as:
Assets = Liability + [Capital + (Income – Expenses) – Drawings]