Accounting equation

The 'basic accounting equation' is the foundation for the double-entry bookkeeping system. It shows how assets were financed: either by borrowing money from someone (liability) or by paying your own money (ownership equity).

Assets = Liabilities + (Shareholders or Owners equity)

How it works

For example: A student buys a computer for $945. This student borrowed $500 from his best friend and saved another $445 from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.

The formula can be rewritten:

Assets - Liabilities = (Shareholders or Owners equity)

Now it shows owner's interest is equal to property (assets) minus debts (liabilities). Since in a company owners are shareholders, owner's interest is called shareholder's equity. Every accounting transaction affects at least one element of the equation, but always balances. Simplest transactions also include:

Transaction Number	Assets		Liabilities		Shareholder's Equity		Explanation
1	+	6,000			+	6,000	Issuing stocks for cash or other assets
2	+	10,000	+	10,000			Buying assets by borrowing money (taking a loan from a bank or simply buying on credit)
3	−	900	−	900			Selling assets for cash to pay off liabilities: both assets and liabilities are reduced
4	+	1,000	+	400	+	600	Buying assets by paying cash by shareholder's money (600) and by borrowing money (400)
5	+	700			+	700	Earning revenues
6	−	200			−	200	Paying expenses (e.g. rent or professional fees) or dividends
7			+	100	−	100	Recording expenses, but not paying them at the moment
8	−	500	−	500			Paying a debt that you owe
9		0		0		0	Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities

Balance sheet

An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity, as well as totals to ensure that it balances.

History

Luca Pacioli is notable for including the first published description of the method of keeping accounts that Venetian merchants used during the Italian Renaissance, known as the double-entry accounting system. However, recently some historians and experts feel that this was already being used by the Arabs and Muslim traders with whom the Venetians would have had contact. They argue that even though Luca Pacioli formally introduced it to Europe, the credit should still go to Eastern merchants who had been using it years before. This claim is yet to be accepted by the academic community as it forces a rethink of several other aspects in this field.