The Accounting Equation

Introduction:

At the heart of accounting is what is known as the accounting equation. This note will discuss this equation, its various forms, and the meaning of its constitutive elements (assets, liabilities, and capital).

Understanding The Accounting Equation:

A. Basic Form:

In its most basic form, the accounting equation is:

For example, before the start of a farming business called Farmex Ghana Ltd., the owner of the Farmex may decide to:

i. Transfer Ghc 100,000 from his pension to Farmex Ghana Ltd. to purchase seeds.

ii. Give his old pickup truck to Farmex Ghana Ltd. for transporting farm produce.

The above are the resources the owner of Farmex Ltd. introduced into Farmex. At this point, the resources of Farmex Ltd. only consist of the resources that were given to it by its owner, the Ghc 100, 000 and the pickup truck.

B. Replacing the Basic Form with Standard Terminology:

i. The phrase “resources introduced into the business by its owner” is overly verbose. In accounting, this phrase is simply referred to as “capital.” It is also common to see this phrase referred to as “equity.”

ii. The phrase “resources in the business,” is also referred to as “assets.”

In light of the above, we may rewrite the basic form of the accounting equation as:

C. Standard Form of the Accounting Equation:

The standard form of the accounting equation is:

Liabilities are resources introduced into the business by third parties (not the owner of the business), such as goods supplied on credit, loans, among others, which ultimately have to be repaid. For example, after the commencement of operations at Farmax Ltd., a bank may offer to give it a loan of Ghc 500,000 to enable it to expand production. The resources in Farmex will now consist of:

i. The Ghc 100,000 that was given to it by its owner as capital.

ii. The old pickup truck that was given to it by its owner, also as capital.

iii. And the Ghc 500,000 that was given to it by the bank.

This Ghc 500,000, being a resource introduced into the business by a third party (bank), is what is referred to as liability. Once the value of this liability is added to the value of the capital in the business, we get the value of the assets in the business.

The Accounting Equation in Practice:

In any business, the following activities commonly occur:

i. Goods are acquired for cash or credit.

ii. Goods are sold for cash or credit.

iii. The owner introduces addition capital into the business.

All of these, individually, have an effect on the accounting equation. Essentially, the nature of their effect is such that it always keeps the accounting equation true. We now examine the effect of the above activities on the accounting equation.

i. Acquisitions of Goods by Cash:

When a business acquires goods, it may do so by cash or on credit. If the business acquires the goods by cash, the value of cash decreases. However, there is an increase in the value of the acquired goods in the business by the same amount for which it was acquired.

For example, if a business had Ghc 600,000 in its bank account, consisting of Ghc 100,000 from its owner (capital) and Ghc 500,000 bank loan (liability), and it purchase goods worth Ghc 200,000, its bank balance reduces by the Ghc 200,000 that was used to purchase the goods . At the same time, it now has goods that is also worth Ghc 200,000. This is how the transaction will affect the accounting equation:

Accounting Equation Before the Transaction:

Accounting Equation After the Transaction:

After the transaction, the amount of cash decreases by the Ghc 200,000 that was used to purchase the goods. The good news is that the business now has goods valued at Ghc 200,000. The goods are an asset of the business, and their value will be added to the total value of assets in the business. In light of this, the accounting equation will now look as follows:

Acquisition by Credit:

If the goods were acquired by credit instead of by cash, the value of the goods will increase by Ghc 200, 000, the value of cash remains the same, but the value of liabilities will also increase by Ghc 200,000. The accounting equation will now look as follows:

ii. Sale of Goods:

Receiving Cash Upon the Sale of Goods:

If goods are sold for cash, the value of the cash increases and the value of the goods reduces by the same value that was received in cash. For example, a business has capital of Ghc 100, 000 and a bank loan of Ghc 500, 000. This results in its cash (assets) being Ghc 600, 000. If the business bought goods for cash, Ghc 200, 000, its cash reduces, but the value of its goods also increases by the same Ghc 200, 000. If it later sold goods worth Ghc 100, 000, its cash will increase by Ghc 100, 000, and its goods will simultaneously reduce by Ghc 100, 000. The accounting equation will look as follows:

Before Sale Transaction:

After Sale Transaction of Ghc 100, 000:

Selling Goods on Credit:

If the goods were sold on credit, the value of cash will remain the same because cash was not received, but the value of goods will reduce because goods were sold out. However, instead of cash, the business receives another asset called accounts receivable, which is just a fancy way of saying “debtor”.

iii. Introduction of Capital into the Business:

At some point the owner of a business may want to expand his business. He can do so by introducing more capital, say Ghc 100, 000 more. This amount, being cash, will be added to the cash of the business. When this happens, the account equation will look like this:

Capital (Existing Capital + Newly Introduced Capital) + Liability = Assets (Existing Value of Assets + Amount Added to the Assets by Newly Introduced Capital)

Consider the following:

i. On 1 ^st January, 2025, the owner of Farmex deposited Ghc 100, 000 in his bank as capital for Farmex.

ii. On 2 ^nd January, 2025, Farmex was granted a loan of Ghc 500, 000 by Ecobank.

iii. On 3 ^rd January, 2025, the owner of Farmex decided to add Ghc 100, 000 to the amount he had initially deposited.

The effect of the above will be that before the 3 ^rd of January, Farmex had assets valued at Ghc 600, 000, which consisted of the Ghc 100, 000 deposited by its owner (Capital) and the Ghc 500, 000 given by Ecobank (Liability). The accounting equation would have looked like this (before 3 ^rd January)

After the third, the accounting equation would look like this:

Conclusion:

This note simply explained what is meant by the accounting equation and the meaning of its constitutive elements of capital, assets, and liability. The note is merely an introduction and in subsequent notes, the equation and its elements will be explained in detail.