Discuss the basic accounting equation

Dr. Le Thi Hong Phuong

There are many accounting equations (also called balance sheets), but only one of them is called the fundamental accounting equation. It is the equation:

Total assets = Total capital (1)

This article attempts to explain the “fundamental” nature of the above equation. According to the author, equation (1) is “fundamental” for the following reasons:

Firstly : That equation reflects the object of accounting as assets with two independent sides but always balanced in total. Indeed, the assets of the unit are the embodiment of capital invested in the operation of the enterprise, showing the economic potential and the ability to bring benefits to the unit in the process of using it. However, assets are not randomly obtained and the formation of each asset is associated with certain financial obligations that the unit must perform such as paying creditors or preserving capital and generating profits for the owner. If the right side of the basic accounting equation is relatively specific and can be easily recognized intuitively, the left side of the equation is always abstract - that is the explanation of the origin of the assets that the unit currently has, showing the economic relationship between the unit and organizations, governing agencies, and functional agencies of the State, regulating the scope and purpose of using the assets.

Second: Equation (1) is the origin of other accounting equations or can be expressed more figuratively as the mother equation that gives birth to the child equations. If we separate the capital side into the sum of equity and liabilities and then reverse the sides, we have the financial equation:

Owner's Equity = Total Assets – Total Liabilities (2)

Equation (2) shows the principle of adjusting any "deviation" if any in equation (1). From equation (2), it can be implicitly understood that the owner's capital is what remains from the total assets after all debts have been paid. From that, all asset fluctuations due to business results or other subjective and objective reasons must be calculated for the owner to enjoy or bear, or in other words, the owner must bear the profit and loss.

Because the assets and capital of the unit always fluctuate during the operation, equation (1) can only be calculated at certain times, usually at the end of the period. To have data on the basic accounting equation at the end of the period, people calculate the final figures of each term in the equation based on the beginning of the period data (ie the end of the previous period) and then adjust for the increase or decrease in the number of fluctuations during the period. From there, we have the following equations:

Equation (3) can be more detailed for each type of asset such as cash, inventory, receivables, fixed assets... For example, we have the following cash flow equation:

For the terms on the left side of equation (1), the final number is calculated as follows:

In which, equity increased and decreased during the period due to 2 main reasons:
- Due to the owner adding or withdrawing capital
- Due to business performance (if there is profit, it increases, if there is loss, it decreases)
From this, equation (5) can be presented as follows:

Changing the sides of equation (6), we will have the equation to calculate business results based on comparing the changes in equity at the end of the period compared to the beginning of the period:

In which, the business results in the period are calculated based on the matching principle of accounting by comparing the total net income realized in the period with the total cost of generating that income:

If we plug equation (9) into equation (7), we will see that income varies in the same direction (increases) while expenses vary in the opposite direction (decreases) with equity. Both expenses and income are represented on the capital side and are therefore abstract concepts. If capital explains the reason for existing assets, expenses and income explain the reason for the increase or decrease in assets due to business activities.

Equation (1) reflects assets and capital in a "static" state (at certain points in time), while equations (3) to (8) reflect accounting objects in a "dynamic" state (in a certain period).

Third: the basic accounting equation determines the accounting method of recording and calculating. Equations (3) to (8) are the basis for designing accounting accounts with two sides, Debit - Credit, the same balances at the beginning and end of the period and the increase and decrease during the period (long-term accounts, tracking accounting objects from this period to the next). Equation (9) shows the method of calculating business results according to the matching principle of accounting and is the basis for designing income and expense accounts, determining business results). The existence of the basic accounting equation (recording assets associated with their sources of formation) is the underlying reason why the double-entry method - the basic accounting method - is widely implemented in all operating situations. That also explains why objects outside the basic accounting equation can only be recorded as a single entry, not double entry, and if double entry is desired, that object must be included in the equation (for example, financial lease assets that were previously recorded as a single entry, after being included in the basic accounting equation along with long-term debt, can be double entered). The basic accounting equation is also used to check the accuracy of the accountant's recording and calculation work. Accountants must record and calculate so that at any time the basic accounting equation can be performed. If there is a discrepancy between total assets and total capital at any time, it proves that there is an error, mistake or fraud in the accounting recording and calculation.

Fourth : the basic accounting equation is the foundation of financial statements. The balance sheet - the main financial statement is a detailed illustration of the basic accounting equation. The income statement shows the results calculated according to formula (9) and is closely related to the fluctuations in assets and capital sources in the balance sheet through formula (7). The cash flow statement prepared by the direct method reflects the fluctuations in cash according to formula (4), while the indirect method is to judge the fluctuations in other assets and capital sources to cash based on the principles of the basic accounting equation:

Cash = Liabilities + Owner's Equity - Assets other than cash (10)

Equations (3) to (8) are all used in the explanation in the Notes to the financial statements. In short, the basic accounting equation is the thread that connects and connects the system of financial statements.