Accounting Equation Definition

Accounting Equation Definition

Accounting Equation Definition

What is the Accounting Equation

The accounting equation plays a significant role as the foundation of the double entry bookkeeping system. The primary aim of the double entry system is to keep track of debits and credits, and ensure that the sum of these always matches up to the company assets, a calculation carried out by the accounting equation.

Hence, as of Jan 15, only 3 accounts exist with a balance – Cash, Furniture A/C and Service Revenue (the rest get net off during the period of the whole transaction by Jan 15). Only those accounts which exist with a balance (positive or negative) as on a particular date get reflected on the balance sheet.

Hence, the account from where the amount is withdrawn gets credited and there needs to be an account debited for the asset purchased (the account which relates to the asset purchased gets debited). Shareholders’ equity is the capital the owners have invested in the firm. Business profits retained from prior periods also qualify as capital or equity (retained earnings).

The certificates include Debits and Credits, Adjusting Entries, Financial What is cash flow Statements, and Working Capital and Liquidity. Click here to learn more.

Current borrowings refers to the short-term obligation a company has to take on in the regular course of business. For example, buyer’s credit for the purchase of a stock or a bank overdraft. Mathematically, Liabilities equals the difference between total assets and owner’s equity (Total Assets – Equity). It represents the owner’s own investment into the business.


If you know any two parts of the accounting equation, you can calculate the third. Each side of the accounting equation has to equal the other because you must purchase things with either debt or capital. Financial statements are written records that convey the business activities and the financial performance of a company. Financial statements include the balance sheet, income statement, and cash flow statement. For all the examples on the next pages, it will be assumed that before any transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are $5,000 each.

Therefore, assets of an entity will always equal to the sum of its liabilities and equity. Owner’s Equity or Stockholders’ Equity refers to how much of the business belongs to you (or, if your business issues stock, to the stockholders). It’s also expressed as assets minus liabilities, and is not to be confused with the value of the business.

©2019 Fundbox, Inc. All rights reserved. If you purchase equipment for $8,000, your liabilities increase by $8,000, and the owner’s equity decreases by $8,000.

Beyond this, however, it helps to measure how profitable your business is. The accounting equation is the foundation of your company’s balance sheet, which expresses your business’s assets, liabilities, and owner’s or shareholder’s equity in detail. In Section 2 we looked at the three elements of the accounting equation – assets, liabilities and capital – and how these three elements are presented in the balance sheet.

  • Inventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated.
  • Now it shows owners’ equity is equal to property (assets) minus debts (liabilities).
  • The balance sheet can tell you how much money the business has in the bank and how likely it is that the business will be able to meet all of its financial obligations.

This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly. Thus, the accounting equation is an essential step in determining company profitability.

Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting. The accounting equation is considered to be the foundation of the double-entry accounting system. The accounting equation shows on a company’s balance sheet whereby the total of all the company’s assets equals the sum of the company’s liabilities and shareholders’ equity.

Hence, the total assets should always be equal to the total liabilities in a balance sheet, which fundamental forms the basis of the whole accounting system of any company when it follows the double-entry bookkeeping system. Regardless of the type of transaction, when it’s recorded properly, the accounting equation stays in balance. If you know any two of the three components of the accounting equation, you can calculate the third component. Examples of liabilities include bank loans, credit accounts or accounts payable.

Accounts payable are the accounts that a business owes money to, such as suppliers. Once you understand the accounting formula basics, you’ll have a better grasp of the contents of a balance sheet. The accounting formula also helps explain the relationship between a company’s financial statements. This transaction affects only the assets of the equation, therefore there is no corresponding effect in liabilities or shareholder’s equity in the right side of the equation.

A company shows these on the balance sheet. A liability occurs when a company has undergone a transaction that has generated an expectation for a future outflow of cash or other economic resources. Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets.

What is the Accounting Equation

This transaction affects both sides of the accounting equation; both the left and right side of the equation increase by +$250. For every transaction, both sides of this equation must have an equal net effect. Below are some examples of transactions and how they affect the accounting equation. Inventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated. It is often deemed the most illiquid of all current assets – thus, it is excluded from the numerator in the quick ratio calculation.

What is the Accounting Equation What is the Accounting Equation

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