Fundamental Accounting Formula

Fundamental Accounting Formula

Double entry accounting is logically predicated on the fundamental accounting formula. The formula is mentioned below:

Assets = Liabilities + Shareholder’s Equity

The three parts of the fundamental accounting formula are:

  • Assets: Assets of a business can be tangible or intangible and may include cash, accounts receivable, inventory and fixed assets
  • Liabilities: These are the mandatory debts that are to be returned to the creditors such as accounts payable, accrued wages and loans
  • Shareholder’s Equity: These are the funds obtained from the investors of a business along with the overall profits that are yet to be distributed among the investors

Actually, a business requires liabilities and shareholder’s equity to retrieve ample funding for the assets that are required to be operated.

The fundamental accounting formula should balance always, that is, the left hand side must always equate to the right hand side. If it is not balanced, this means that a journal entry was not entered correctly and must be fixed before issuing financial statements. This is evident through the balance sheet which is also referred to as statement of financial position (SOFP). In a balance sheet, the accumulated total of all assets should be equivalent to the sum of all liabilities and shareholder’s equity.

The fundamental accounting formula is one of the main foundations of accounting as it is responsible for forming the basis of recording all accounting transactions. So, if both sides of the fundamental accounting formula are not equal to each other, it indicates an error in the accounting system which needs to be rectified.

You can see in the table given below how numerous transactions are recorded within the ambit of the accounting equation.

Keep in mind that the fundamental accounting formula is only related to the double entry bookkeeping system where all entries are desired to balance the formula. This formula is not valid for single entry system.