The Accounting equation

This chapter introduces the accounting equation, the foundation of financial accounting. It explains how assets, liabilities, and equity relate to each other, guided by the business entity concept and the duality principle. Using practical scenarios, you’ll see how transactions affect the equation and how this links to the statement of financial position and the statement of profit or loss. The chapter also explains how profit, drawings, and additional capital affect equity and, therefore, net assets.

Learning objective

By the end of this lesson, you should be able to:

• Explain and apply the accounting equation
• Identify and explain the function of the main data sources in an accounting system.
• Describe the key features of a computerised accounting system, including the use of external servers to store data (the cloud).
• Describe how an accounting system contributes to providing useful accounting information and complies with organisational policies and deadlines.

Accounting equation

The accounting equation is the basis of the statement of financial position. Its building blocks are assets, liabilities, and equity.

The equation tells us that the total assets of a business (what it owns and/or controls) will always equal the total of its equity and liabilities (how those assets are financed - by the owner and by outsiders).

This idea is guided by the business entity concept, which treats the business as separate from its owners. So, when an owner puts money into the business or takes money out, we record it as a transaction between the owner and the business.

The equation also relies on the principles of duality and double-entry bookkeeping. Every transaction has two equal effects (a debit and a credit), which keeps the accounting equation balanced.

Illustration: Accounting equation

The scenarios below show how transactions, when posted to the general ledger, keep the accounting equation in balance.

Scenario one
Chris Deva started a business with$40,000 for the retail of phones. He registers and names the business Achievable Ltd. Effect on the equation: Chris Deva introduces $40,000 as capital. Achievable Ltd. now has $40,000 cash (asset) and $40,000 capital (equity). The accounting equation becomes:

Assets	$		Equity	$		Liability
Cash	40,000	=	Capital	40,000	+	0
	40,000	=		40,000	+	0

Scenario two
Chris Deva considered that the$40,000 initially invested was small; hence, he borrowed an additional $25,000 from his mate for business purposes. Effect on the equation: The business receives an additional $25,000 cash (asset). At the same time, it takes on a loan obligation (liability) of $25,000.

Assets	$		Equity	$		Liability
Cash	65,000	=	Capital	40,000	+	Loan	25,000
	65,000	=		40,000	+		25,000

Scenario three
Chris Deva makes a payment of$20,000 to acquire a retail shop. Effect on the equation: Achievable Ltd. gains a shop (asset) and gives up cash (asset). Total assets stay the same, but their form changes. Cash decreases from $65,000 to $45,000.

Assets	$		Equity	$		Liability	$
Cash	45,000
Shop	20,000		Capital	40,000	+	Loans	25,000
	65,000	=		40,000	+		25,000

Scenario four
Chris Deva stocked the shop with his first set of phones, which he acquired for$10,000. Effect on the equation: Cash (asset) decreases by $10,000, and inventory (asset) increases by $10,000. Total assets are unchanged, so the equation remains balanced.

Assets	$		Equity	$		Liability	$
Cash	35,000
Shop	20,000
Inventory	10,000		Capital	40,000	+	Loans	25,000
	65,000	=		40,000	+		25,000

Scenario five
Chris Deva’s mate immediately requested payment of part (i.e,. 50% of 25,000) of the amount granted him. Effect on the equation: Paying part of the loan (i.,e.$12,500) reduces cash (asset) and reduces the loan balance (liability) by the same amount.

Assets	$		Equity	$		Liability	$
Cash	22,500
Shop	20,000
Inventory	10,000		Capital	40,000	+	Loans	12,500
	52,500	=		40,000	+		12,500

Profit or loss and drawings introduced

The owner (or shareholders in a company) is entitled to the profit or loss made by the business. The owner can either:

• withdraw some of the profit, or
• leave it in the business to support operations.

In Scenario one, the $40,000 Chris Deva invested was recorded as equity (capital). Any profit the owner leaves in the business (retained earnings) increases equity. In contrast, drawings (or dividends in a company) reduce equity.

So, in the accounting equation:

• profit increases equity
• drawings (and dividends) decrease equity

Profit or loss comes from the difference between income and expenses, and it affects equity directly. The next scenarios show how profit and drawings flow through the accounting equation.

Illustration: Accounting equation with profit/loss and drawings

Scenario six
Chris Deva sold the inventory, which cost him $ 10,000, for $15,000 and received cash. Effect on the equation:

• Inventory (asset) decreases by $10,0,00, and we recognise the expense of $10,000.
• Cash (asset) increases by $15,000, and revenue increases by the same amount.
• Profit arises as revenue minus expenses ($5,000 = 15,000 - $10,000)

Assets	$		Equity	$		Liability	$
Cash	37,500
Shop	20,000		Capital	40,000		Loans	12,500
Inventory	0		Profit	5,000
	57,500	=		45,000	+		12,500

Scenario seven
Chris Deva withdrew cash amounting to $2,500 as his share of the profit. Effect on the equation: Cash (asset) decreases by $2,500. Equity also decreases by $2,500 because the amount of profit retained in the business is reduced.

Assets	$		Equity	$		Liability	$
Cash	35,000
Shop	20,000		Capital	40,000		Loans	12,500
Inventory	0		Profit	2,500
	55,000	=		42,500	+		12,500

The statement of financial position and statement of profit or loss

The accounting equation is a direct reflection of the statement of financial position (balance sheet). Once profit or loss and drawings are introduced, they affect the equation through equity. This is the link between the statement of profit or loss and the statement of financial position: profit (or loss) changes equity, and that change appears in the statement of financial position.

The equation can be rewritten as:

$$\text{Asset}-\text{Liability}=\text{Equity}$$

Here,

$$\text{Asset}-\text{Liability}=\text{Net Asset}$$

where

$$\text{Net Asset}=\text{Equity}$$

So, any change in equity (from profit, drawings, or additional capital) results in an equal change in net assets.

Effect of profit, drawings, and capital on equity

The table presents a summary of the effect of profit, drawings, and capital on equity as well as net assets.

Net asset computation

The format for determining net asset movement is:

Mathematically, we can express it as:

$$\text{Closing Net Asset}=\text{Opening Net Asset}+\text{Profit}+\text{Additional Capital}-\text{Drawings}$$

Illustration 1: Calculating the profit

On 1 Jan. 2025, Achievable had a net asset of $45,000. On 31st Dec. of the same year, the net asset had increased to $50,500. During the year, the owner had withdrawn $2,500 but introduced no additional capital. You are required to calculate the profit for the year. Suggested solution:
You can determine the profit using either approach below. The statement approach helps you see how the figures fit together. Statement approach
Rewrite the format and fill in the items with their figures. Use the balancing-off an account approach to find the missing figure.

The balancing figure is the missing amount needed to make the statement total correctly. Mathematical approach

• Quote the formula for net asset movement computation and make profit the subject.

$$\text{Profit}=\text{Closing NA}-\text{Opening NA}-\text{Additional Capital}+\text{Drawings}$$

• Substitute the figures and find the profit.

$$\text{Profit}=\$50,500-\$45,000-0+\$2,500=\$8,000$$

Illustration 2: Calculating the net asset

On 1st January 2025, AKA Mant enterprise net assets increased by $18,000 during the year. The profit for the year was $8,000, and the owner withdrew $6,000 for personal use. Calculate the capital introduced during the period. Mathematical approach

Do you know the answer?