5. Basic accounting equation

Before we can proceed with the basic accounting equation we need to understand claims:

A company's assets belong to the resource providers who are said to have claims on the assets.

In other words, each asset has its own source provided by an owner or creditor. So, there can't be a claim without an appropriate asset and vice versa. Based on this statement, we can define the basic accounting equation as:

Assets = Claims

Claims are divided into two categories:

• Creditors' claims that are called liabilities
• Owners' claims that are called equity

Taking this into account, the basic accounting equation can also be presented as follows:

Assets	=	Claims
Assets	=	Liabilities + Equity

Liabilities are debts and obligations of a company.

Equity is what the company "owes" to owners. Equity is also called net assets or residual equity.

The amount of total assets minus total liabilities equals equity. Because equity equals the difference between assets and liabilities, it is also called net assets.

If a company goes bankrupt, liabilities are paid off first to creditors, while equity is the last to be distributed. Therefore, owners' equity is also called residual equity.

Let us look at an example of the basic accounting equation. Suppose a company has assets of $800, liabilities of $300, and equity of $500. These amounts will be shown in the basic accounting equation as follows:

Illustration 2: Example of basic accounting equation

Assets	=	Claims
Assets	=	Liabilities	+	Equity
$800	=	$300	+	$500

6. Effects of transactions on the basic accounting equation

Let us know examine how different transactions affect the basic accounting equation. We will take a look at several transactions separately.

1) Friends Company is created when the owners pool $5,000 into the business. The effect of the contributions on the accounting equation is as follows:

Illustration 3: Effect of cash contribution

		Claims
Assets	=	Liabilities	+	Equity
+$5,000	=		+	+$5,000

Note that the amount of this single transaction is recorded twice. The first time it is recorded as an asset and the second time it is recorded as equity (the asset source). In accounting any transaction is recorded at least twice, as a rule. This rule is known as double-entry bookkeeping.

The double-entry bookkeeping rule states that any transaction is recorded at least twice.

Because this transaction provided assets to the company, it is called an asset source transaction. An asset source transaction is one of the four types of accounting transactions.

Asset source transactions result in an increase in an asset account and in one of the claim accounts (liability or equity accounts).

2) Next, assume that Friends Company acquires an additional $2,000 of assets by borrowing cash from creditors (e.g., taking a loan from a bank). This is also an asset source transaction. In the table below the beginning balances are derived from the ending balances of the previous transaction:

Illustration 4: Effect of borrowing

			Claims
	Assets	=	Liabilities	+	Equity
Beginning balance	$5,000	=		+	$5,000
Effect of borrowing	+$2,000	=	+$2,000
Ending balance	$7,000	=	$2,000	+	$5,000

Equity is usually viewed as a source of assets, and that's why it is necessary to subdivide the owner's interest into two components. First, owners' claims are established when a business acquires assets from owners. These claims result from the contributions of capital resources by the owners; therefore, they are frequently called contributed capital.

Contributed capital is a component of equity resulting from contributions of capital resources by owners.

The second source of assets associated with equity occurs when a business obtains assets through its earnings activities. This source is called retained earnings.

Retained earnings are a component of equity resulting from earnings activities.

Taking into account the definitions above, the basic accounting equation can be presented like this:

Assets	=	Liabilities	+	Equity
				Contributed Capital	+	Retained Earnings