The accounting equation—Assets = Liabilities + Equity—is the structural rule that underpins all double-entry bookkeeping systems. It ensures that financial statements remain balanced and accurate after every transaction. This relationship, recognized under IAS 1 Presentation of Financial Statements and FASB ASC 205-10, applies to all entities regardless of size, sector, or accounting framework. The following examples demonstrate how the equation functions in real business scenarios, showing its direct effect on assets, liabilities, and equity.
1. Example 1: Starting a Business
Scenario
An entrepreneur invests $50,000 of personal capital to start a business. The company purchases $40,000 of equipment and keeps $10,000 in cash.
Application
- Assets: Cash ($10,000) + Equipment ($40,000) = $50,000
- Liabilities: $0
- Equity: $50,000 (Owner’s Capital)
Result
Assets ($50,000) = Liabilities ($0) + Equity ($50,000)
This transaction creates the initial balance sheet. The entire business is financed through owner’s equity, meaning no external debt obligations exist. Under IFRS Conceptual Framework §4.63, equity represents the residual interest after liabilities are deducted.
2. Example 2: Purchasing Inventory
Scenario
The business purchases $20,000 of inventory on credit from a supplier, creating an obligation to pay later.
Application
- Assets: Inventory (+$20,000)
- Liabilities: Accounts Payable (+$20,000)
- Equity: No change
Result
Assets ($20,000) = Liabilities ($20,000) + Equity ($0)
The transaction increases both assets and liabilities equally, keeping the equation balanced. It demonstrates the accrual principle under IAS 2 Inventories and IFRS 9 Financial Instruments.
3. Example 3: Earning Revenue
Scenario
The business earns $15,000 in revenue from service income received in cash.
Application
- Assets: Cash increases by $15,000.
- Liabilities: No change.
- Equity: Retained Earnings increase by $15,000 (net income).
Result
Assets ($15,000) = Liabilities ($0) + Equity ($15,000)
Revenue inflow directly raises both total assets and equity through retained earnings. This aligns with IFRS 15 Revenue from Contracts with Customers and illustrates how profit enhances net worth.
4. Example 4: Paying Expenses
Scenario
The company pays $5,000 in rent, reducing cash and decreasing equity because expenses reduce profits.
Application
- Assets: Cash decreases by $5,000.
- Liabilities: No change.
- Equity: Retained Earnings decrease by $5,000.
Result
Assets (-$5,000) = Liabilities ($0) + Equity (-$5,000)
This illustrates the matching principle—expenses are recognized in the same period as related revenues. Under IAS 1, such reductions in income lower retained earnings but maintain equation balance.
5. Example 5: Taking a Loan
Scenario
The business borrows $25,000 from a bank, receiving cash in exchange for a loan payable.
Application
- Assets: Cash increases by $25,000.
- Liabilities: Loan Payable increases by $25,000.
- Equity: No change.
Result
Assets ($25,000) = Liabilities ($25,000) + Equity ($0)
The balance sheet expands in size but remains in equilibrium. Debt financing raises both total assets and total obligations, illustrating IFRS 9 recognition of financial liabilities.
6. Example 6: Purchasing Equipment with a Loan
Scenario
The company acquires new equipment valued at $30,000 through a long-term loan covering the full cost.
Application
- Assets: Equipment increases by $30,000.
- Liabilities: Loan Payable increases by $30,000.
- Equity: No change.
Result
Assets ($30,000) = Liabilities ($30,000) + Equity ($0)
This case shows how financing decisions affect the composition of assets and liabilities without altering equity. The transaction meets the capitalization criteria in IAS 16 Property, Plant and Equipment.
The Accounting Equation in Action
The accounting equation guarantees that every debit has a corresponding credit, preserving balance and accuracy across all ledgers. In practice:
- Investments and revenues increase both assets and equity.
- Expenses and withdrawals reduce equity and assets.
- Borrowings increase both assets and liabilities.
| Transaction Type | Effect on Assets | Effect on Liabilities | Effect on Equity |
|---|---|---|---|
| Owner Investment | Increase | No Change | Increase |
| Purchase on Credit | Increase | Increase | No Change |
| Revenue Earned | Increase | No Change | Increase |
| Expense Paid | Decrease | No Change | Decrease |
| Loan Obtained | Increase | Increase | No Change |
Each example reflects the fundamental rule of financial balance recognized worldwide under IFRS and GAAP frameworks. The consistency of this relationship enables accountants, investors, and auditors to interpret financial performance accurately and ensure transparency across all financial reports.
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