The Accounting Equation is the foundation of the Double Entry System of Accounting. It shows the relationship between a business’s Assets, Liabilities, and Equity (Capital).
The equation states that the total assets of a business are always equal to the sum of its liabilities and owner’s equity. Every financial transaction affects at least one component of the equation, but the equation always remains balanced.
Basic Accounting Equation
The most commonly used accounting equation is:
Assets = Liabilities + Equity
Where:
- Assets = Resources owned by the business.
- Liabilities = Obligations or debts owed to outsiders.
- Equity (Capital) = Owner’s claim on the assets of the business.
Other Forms of the Accounting Equation
The accounting equation can be written in different forms:
1. Assets = Liabilities + Owner’s Equity
Assets = Liabilities + Owner’s Equity (OE)
2. Assets = Shareholders’ Equity + Liabilities
Assets = Shareholders’ Equity (SE) + Liabilities
Both forms express the same accounting relationship.
Rearranged Forms of the Accounting Equation
The equation can also be rearranged to calculate Owner’s Equity or Shareholders’ Equity.
Owner’s Equity
Owner’s Equity = Assets − Liabilities
Shareholders’ Equity
Shareholders’ Equity = Assets − Liabilities
These forms indicate that equity represents the residual interest in the assets of the business after deducting liabilities.
Accounting Equation (CBSE/NCERT Form)
According to Class 11 NCERT Accountancy, the accounting equation is expressed as:
Assets = Liabilities + Capital
Here, Capital represents the owner’s investment in the business.
Working Capital Equation
For current assets and current liabilities:
Current Assets = Current Liabilities + Working Capital
This equation shows that:
Working Capital = Current Assets − Current Liabilities
Working Capital measures the short-term financial strength of the business.
Total Assets
Total Assets can be calculated as:
Total Assets = Equity + Total Liabilities
It can also be calculated as:
Total Assets = Current Assets + Non-Current Assets
Components of Total Assets
- Current Assets – Assets expected to be converted into cash within one year.
- Non-Current Assets – Long-term assets used in business operations.
Total Liabilities
Total Liabilities are calculated as:
Total Liabilities = Current Liabilities + Non-Current Liabilities
Components
- Current Liabilities – Obligations payable within one year.
- Non-Current Liabilities – Long-term obligations payable after one year.
Equity Calculation
Shareholders’ Equity can be calculated as:
Equity = Share Capital + Retained Earnings + Reserves − Treasury Stock
Components of Equity
- Share Capital – Amount invested by shareholders.
- Retained Earnings – Accumulated profits retained in the business.
- Reserves – Profits set aside for future use.
- Treasury Stock – Company’s own shares repurchased (deducted from equity).
Effect of Transactions on Accounting Equation
Every accounting transaction affects at least one element of the accounting equation, but the equation always remains balanced.
Common Transactions
| Transaction | Effect on Accounting Equation |
|---|---|
| Issue of share capital for cash | Assets ↑, Equity ↑ |
| Purchase of assets by taking a loan | Assets ↑, Liabilities ↑ |
| Sale of assets to repay liabilities | Assets ↓, Liabilities ↓ |
| Purchase of assets using owner’s funds and borrowing | Assets ↑, Liabilities ↑, Equity ↑ |
| Earning revenue | Assets ↑, Equity ↑ |
| Payment of expenses or dividends | Assets ↓, Equity ↓ |
| Recording expenses without immediate payment | Liabilities ↑, Equity ↓ |
| Payment of outstanding debt | Assets ↓, Liabilities ↓ |
| Sale of one asset for cash | One asset decreases and another asset increases; Total Assets unchanged |
Important Concept
Although individual assets, liabilities, or equity may increase or decrease, the Accounting Equation always remains in balance.
Expanded Accounting Equation
The accounting equation can be expanded to show the detailed components of Equity.
Owner’s Equity
Owner’s Equity = Contributed Capital + Retained Earnings
Retained Earnings
Retained Earnings = Net Income − Dividends
Net Income
Net Income = Revenue − Expenses
After substituting these relationships into the basic accounting equation, we get the Expanded Accounting Equation:
Expanded Accounting Equation
Assets = Liabilities + Contributed Capital + Revenue − Expenses − Dividends
This expanded equation explains how revenues increase equity, while expenses and dividends reduce equity.
Difference between Basic and Expanded Accounting Equation
| Basic Accounting Equation | Expanded Accounting Equation |
|---|---|
| Assets = Liabilities + Equity | Assets = Liabilities + Contributed Capital + Revenue − Expenses − Dividends |
| Shows overall relationship | Shows detailed components of Equity |
| Simpler form | More detailed analysis of owner’s equity |
Key Points
- The Accounting Equation is the foundation of the Double Entry System.
- Basic Accounting Equation:
Assets = Liabilities + Equity - According to NCERT:
Assets = Liabilities + Capital - Owner’s Equity = Assets − Liabilities
- Working Capital = Current Assets − Current Liabilities
- Total Assets = Current Assets + Non-Current Assets
- Total Liabilities = Current Liabilities + Non-Current Liabilities
- Equity = Share Capital + Retained Earnings + Reserves − Treasury Stock
- Every accounting transaction affects at least one component of the accounting equation.
- The accounting equation always remains balanced.
- Expanded Accounting Equation:
Assets = Liabilities + Contributed Capital + Revenue − Expenses − Dividends
Quick Revision Summary
| Formula | Remember |
|---|---|
| Basic Accounting Equation | Assets = Liabilities + Equity |
| Owner’s Equity | Assets − Liabilities |
| Working Capital | Current Assets − Current Liabilities |
| Total Assets | Current Assets + Non-Current Assets |
| Total Liabilities | Current Liabilities + Non-Current Liabilities |
| Equity | Share Capital + Retained Earnings + Reserves − Treasury Stock |
| Retained Earnings | Net Income − Dividends |
| Net Income | Revenue − Expenses |
| Expanded Accounting Equation | Assets = Liabilities + Contributed Capital + Revenue − Expenses − Dividends |