What Is Fundamental Accounting Equation – Examples And Solutions

Accounting is a critical aspect of any business, regardless of size, fund, structure, and industry. The fundamental accounting equation, also known as the balance sheet equation, calculates the relationship between the assets, liabilities, and owner’s equity. The basic accounting equation evaluates the financial reports and learns about a company’s financial health. The equation is also the foundation of the double-entry accounting system. 

Accounting Equation Definition

The accounting equation is the base of the double-entry bookkeeping method, which most organizations use to ensure that the balance sheet always equals. The left side of the sheet representing the resources should match the right side, which is the source. Before we elaborate, let’s understand the definition of the accounting equation. 

Definition

The accounting equation defines the relationship between a company’s assets, liabilities, and owners equity. Assets owned are everything a business owns, while everything the business owes is liabilities. The owner’s equity is the owner’s share of the total assets. 

Considering the basic accounting equation principles, the left side column of the balance sheet (liabilities) should match the right side (assets). The company owner will be at his best if the assets balance with the liabilities. 

The financial accounting equation is double-entry, where the total debits match every transaction’s total credits. 

Elements in the Accounting Equation Formula

Three primary indicators are used to evaluate the financial position of a business, which can be summarized by using the formula given below:

 OR 

Example: 

Before we delve deeper into some more accounting equation problems, let’s understand the basic elements of the accounting equation: assets, liabilities, and owner’s equity. 

Assets

Assets are resources owned by businesses that are used for production and sales. The general examples of tangible assets include cash, inventory of product assets, accounts receivable, and material assets like customer supplies, office supplies, dishes, computer appliances, land, furniture, buildings, billing, and collection systems. And the intangible assets consist of copyrights, trademarks, and patents. 

The investors or lenders of the business have rights to the business assets. Let’s say a credit giver lends money to a business owner. The creditor has the legal and financial right to a portion of the assets until the debt is paid. 

Liabilities

Liabilities are what businesses owe to their lenders and other third parties. Creditors are entities a business owes money to, like employees, banks, government agencies, and more. Just as assets are classified as current assets and fixed assets, liabilities are also classified similarly. For example, current liabilities are employee payroll, utility, invoices, and supply charges, while long-term liabilities are mortgages, deferred taxes, and bank loans. 

Owner’s Equity 

As mentioned earlier, the owner’s equity is the value of assets the business owner owns. More specifically, it’s the total amount left after the assets are liquidated and liabilities are paid off. Now what causes an increase and decrease in owner’s equity? Let’s find out:

• Rise in the owner’s equity: 

There are two instances when the owner’s equity increases: revenue and additional investment by the owner. Investments are cash that owners put into their firm, which is recorded as the owner’s finances on the balance sheet. On the contrary, revenue is the total profit from sales, lending cash, commissions, renting, etc. 

• Decline in the owner’s equity: 

An owner’s equity declines with a cost and financial debit. Drawing is the money withdrawn from the business, while charges are the charges from utility charges, taxes, wage payments, tool purchases, etc. 

Extended Version of the Accounting Equation

The extended version comprises all the following elements:

• Assets
• Liabilities 
• Owner’s funds
• Owner’s drawings
• Revenues 
• Charges

So the formula should look like this:

Although the formulation gives a complete idea of the relationship between the main financial transaction records of a business, you can arrange and rearrange it into other forms to solve accounting equation problems.

• Owner’s equity = Net Assets – Liabilities 

While it may not make a big difference at first, the entire meaning will change if you shift the owner’s equity to the left-hand side. It suggests creditors priority over owners for meeting their demands. The equation’s main goal is to analyze the business’s investments, credit, charges, bank loan amount paid, profit, accounts payable liability, and other business activities to determine whether the business’s assets increase or decrease and find the actual financial value.  

• Net worth = Assets – Liabilities 

Net worth is synonymous with owner’s equity and follows the same equation. Other term used for owner’s equity is stockholder’s equity (used for public organizations. 

The expanded version of the accounting equation is also formulated as the following:

Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Revenue – Charges – Dividends

• Contributed Capital, also known as Paid-In Capital, is given by the first investors. 
• Beginning Retained Earnings (BRE) is the income not given to the shareholders from the past period.
• Revenue is the fund gained from production and sales 
• Charges are the costs of running different business activities 
• Dividends are the profits given to the shareholders.

Check Out Fundamental Accounting Equation Problems and Solutions

The only way you can expect excellent scores in your accounting assignments is to know how to apply the basic accounting concepts when solving equation problems. Here are some fundamental accounting problems with their solutions for your perusal.

How to Solve a Basic Accounting Equation?

Let’s look at a few accounting equation examples with solutions to understand the calculations better. 

Example 1

Find the missing factor using the accounting equation transaction formula:

Solution

Example 2

Find the missing factor using the accounting equation transaction formula:

Solution

Example

Find the missing factor using the accounting equation transaction formula:

Solution

Let’s look at another example to understand practical transactions.

Assume the company ABC started business services. We will evaluate their purchase, debit, and other transactions for their first month of work. 

The business owner withdraws money from their bank account and invests $10,000 in Company ABC. This transaction will increase the cash asset and owner’s equity fund by $10,000. So the equation of the transaction will look like this:

Company ABC purchases $1,000 of appliances. Now, there’s an increase and debit of $1,000 on assets as cash will decrease and appliances will increase. The equation of the transaction will look like the following form after the second transaction:

Company ABC purchases $1,500 of supplies on credit. This transaction increases by $1,500. With this purchase transaction, the entry will look in the following form:

ABC receives $1,000 cash from a customer for a purchase. Cash and revenue of the transaction are increased by the same amount of $1,000. The following transactions of the accounting equation would look like below:

1. ABC’s bank account gets debited by $500 for employee salaries. This transaction will decrease the debit amount on the cash and expenses account. Hence, the transaction form  of two accounts will look like:

Now, if you add up the debit and credit amount of the following transactions, you will find the value of one account equals to the other side of the transaction amount of $12,000, as shown below: 

Types of Accounting Problems

Accounting problems are the challenges that result in material financial statement mistakes and undetected errors due to poor internal control, incorrect application of generally accepted accounting principles (GAAP accounting standards), cybersecurity breaches, and regulatory non-compliance. Unchecked accounting issues may result in unfavorable cash flow and misstatement of business profitability. Here’s a list of common accounting challenges businesses generally encounter:

• Payroll errors
• Revenue recognition
• Missing impairment write-downs
• Lease accounting 
• Cash flow statement 
• Insufficient financial analysis
• Outdated accounting software technology 
• Fraudulent activities 
• Inadequate internal control
• Poor security measures 
• Regulatory non-compliance

Limitations of the Accounting Equation

While the accounting equation plays a significant role in determining the connection between the three elements: asset, liability, and equity, it’s not always suitable for learning about financial transactions, investments, funds, bank debts, debit, high credit, inventory purchase cost, business loan, and other business finance-related information. For instance, it doesn’t provide investors or other third parties information about accounts affected, accounts receivable funds, or details on how well the business operates. 

Additionally, there’s no guarantee of a correct answer even if you find debits equal credit transactions. Some errors may not even involve accounting equations. Financial stakeholders must evaluate the results closely to determine if the company has enough supplies and credit amount, or excess, to ensure the long-term development of a newly commenced business. To know more about the limitations of the accounting equations, credit account challenges, and effects of a bank loan, and how to balance inventory cost and funds on the sheet, you can contact an account specialist for detailed information. 

Key Points

With that, we have come to the end of our guide on accounting equations. Let’s quickly recap the main points we’ve covered in the blog:

• The accounting equation is a pivotal bookkeeping tool for all businesses, regardless of size and purpose, representing the relationship between asset, liability, and owner’s equity.
• Business holdings like cash, inventory, buildings, and other similar tangible items are assets, while liabilities are business obligations like an outstanding loan account, tax bills, invoices, and other intangible items. 
• The owner’s equity represents goods belonging to the stakeholders or business owners.
• The equation can be rearranged in three different ways:

• Assets = Liabilities + Owner’s Funds – Owner’s Drawings + Revenues – Charges
• Owner’s equity = Assets – Liabilities
• Net Worth = Assets – Liabilities
• Changes in the equation are recorded through double-entry bookkeeping.
• The balance sheet of an account is a financial statement that gives a detailed explanation of the equation.
• The primary limitation of the equation is that it doesn’t provide a detailed analysis of business operations. 

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