The Accounting Equation

The five Account Types are all related by the Accounting Equation.

This equation is also known as the Balance Sheet Equation because it forms the basis for building a Balance Sheet.

The Balance Sheet Equation is based on a key notion in Accounting.

The Accounting Entity Concept.
Under this concept the Business and the Owner are treated as Separate entities.

When the accounts are kept they are viewed from the point of view of the Business, not the Owner.

The Owner is viewed as someone to whom the business owes money. This gives rise to the Accounting Equation.

What the Business Owns = What the Business Owes

What the "Business Owns" are its Assets.

"What the Business Owes" are its Liabilities plus the money it owes the Owners of the business.

The Balance Sheet equation becomes

Assets = Liabilities + Owner's Equity

or

A = L + OE

This is the basic form of the Balance Sheet Equation.

However after a period of Trading there may be a Profit or a Loss.

This Profit or Loss, belongs to the Owner, it becomes part of Owner's Equity.

Therefore the equation now becomes

A = L + (OE + Profit/Loss)

Profit is the difference between Revenue and its associated Expenses therefore

Profit =Revenue - Expenses

The balance sheet Equation now becomes

A = L + OE + (R - E)

A = L + OE + R - E

Now you can see how all the Account Types relate to each other.

Placing like terms on the same side of the equation

A + E = L + OE + R

We define the elements on the left as Debit items

The elements on the right are called Credit items.

From this you can see we define Assets as Debits.

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