Accounting Equation Overview, Formula, and Examples

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The income and retained earnings of the accounting equation is also an essential component in computing, understanding, and analyzing a firm’s income statement. This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation.

You can see that a journal has columns labeled debit and credit. The debit is on the left side, and the credit is on the right. Journaling the entry is the second step in the accounting cycle.

Basic Accounting Equation Example – How to Calculate

This is posted to the T-account on the debit side. This is posted to the Accounts Payable T-account on the credit side.

When the bill is in cash next month, AP will decrease with a $500 debit and cash will decrease with a $500 credit. In a corporation, capital represents the stockholders’ equity. Thus, the accounting formula essentially shows that what the firm owns has been purchased with equity and/or liabilities. Most businesses have all kinds of things sitting around that don’t appear as assets on their balance sheet. Office supplies, cleaning supplies and other “consumables” — things that get used up by your business — don’t go on the balance sheet as assets. Instead, they’re simply reported as expenses when you buy them.


This reduces the cash account and reduces the retained earnings account. In addition, the accounting equation only provides the underlying structure for how a balance sheet is devised. Any user of a balance sheet must then evaluate the resulting information to decide whether a business is sufficiently liquid and is being operated in a fiscally sound manner. Under the umbrella of accounting, liabilities refer to a company’s debts or financially-measurable obligations. Liability is also classified as current or long-term. Two key elements in accounting are debits and credits. Understand these critical pieces of notation by exploring the definitions and purposes of debits and credits and how they help form the basics of double-entry accounting.

What is the most common form of the accounting equation?

The most commonly used accounting equation is the balance sheet equation, which shows that assets must equal liabilities plus equity. Understanding how to use equations in accounting can help you compare performance over time to see how well a business is doing.

In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly. Thus, the accounting equation is an essential step in determining company profitability. Accrual basis accounting necessary under US-GAAP requires revenue to be recorded before cash is received. Typically revenue is earned when an item ships and the sale is recorded in accounts receivable. Accounts receivable is an asset account that tracks the amounts owed to customers until cash is paid.

Accounting Equation Formula and Calculation accounting transactions with the accounting equation means that you use debits and credits to record every transaction, which is known as double-entry bookkeeping. Accounts payable include all goods and services billed to the company by suppliers that have not yet been paid. Accrued liabilities are for goods and services that have been provided to the company, but for which no supplier invoice has yet been received.

This increases the fixed assets account and increases the accounts payable account. The accounting equation is only designed to provide the underlying structure for how the balance sheet is formulated.