Accounting Equation Overview, Formula, and Examples

For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Parts 2 – 6 illustrate transactions involving a sole proprietorship.Parts 7 – 10 illustrate almost identical transactions as they would take place in a corporation.Click here glendale bookkeeping to skip to Part 7. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.

Although the balance sheet always balances out, the accounting equation can’t tell investors how well a company is performing. The accounting equation is also called the basic accounting equation or the balance sheet equation. This equation should be supported by the information on a company’s balance sheet.

1. As you can see, all of these transactions always balance out the accounting equation.
2. The main premise of the balance sheet in this regard is to show the assets held by the company are equal to the sum of liabilities and equity held by the company at a particular date.
3. This equation sets the foundation of double-entry accounting, also known as double-entry bookkeeping, and highlights the structure of the balance sheet.
4. This includes expense reports, cash flow and salary and company investments.
5. The shareholders’ equity number is a company’s total assets minus its total liabilities.

Examples of the Accounting Equation

Accounting equation describes that the total value of assets of a business entity is always equal to its liabilities plus owner’s equity. This equation is the foundation of modern double entry system of accounting being used by small proprietors to large multinational corporations. Other names used for this equation are balance sheet equation and fundamental or basic accounting equation. The balance sheet is also known as the statement of financial position and it reflects the accounting equation.

It can be defined as the total number of dollars that a company would have left if it liquidated all of its assets and paid off all of its liabilities. Equity represents the portion of company assets that shareholders or partners own. In other words, the shareholders or partners own the remainder of assets once all of the liabilities are paid off. Incorrect classification of an expense does not affect the accounting equation.

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. It is used to transfer totals from books of prime entry into the nominal ledger. Every transaction is recorded twice so that the debit is balanced by a credit. A company’s quarterly and annual reports are basically derived directly from the accounting equations used in bookkeeping practices. These equations, entered in a business’s general ledger, will provide the material that eventually makes up the foundation of a business’s financial statements.

Assets Always Equal Liabilities Plus Equity

Put another way, it is the amount that would remain if the company liquidated all of its assets and paid off all of its debts. The remainder is the shareholders’ equity, which would be returned to them. In other words, the total amount of all assets will always equal the sum of liabilities and shareholders’ equity. Essentially, the representation equates all uses of capital (assets) to all sources of capital, where debt capital leads to liabilities and equity capital leads to shareholders’ equity. The accounting equation states that the amount of assets must be equal to liabilities plus shareholder or owner equity. There are different categories of business assets including long-term assets, capital assets, investments and tangible assets.

Financial statements

To make the Accounting Equation topic even easier to understand, we created a collection of premium materials called AccountingCoach PRO. Our PRO users get lifetime access to our accounting equation visual tutorial, cheat sheet, flashcards, quick test, and more. In order for the accounting equation to hold, Total Assets should ideally be equal to the sum of Total Liabilities and Total Equity. Assets are the resources that are held by the company in order to function and operate in the relevant industry. In this regard, it is also important to point out that assets can be termed as intermediaries that help companies generate considerable money.

If the left side of the accounting equation (total assets) increases or decreases, the right side (liabilities and equity) also changes in the same direction to balance the equation. Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. 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.

If a company keeps accurate records using the double-entry system, the accounting equation will always be “in balance,” meaning the left side of the equation will be equal to the right side. The balance is maintained because every business transaction affects at least two of a company’s accounts. For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount.

Nabil invests $10,000 cash in Apple in exchange for $10,000 of common stock. Assets are resources the company owns and can be used for future benefit. Liabilities are anything that the company owes to external parties, such as lenders and suppliers. Stockholders can transfer their ownership of shares to any other investor at any time.

What is the Accounting Equation?

This also includes debt that might have been taken by the company in order to arrange for finances. Liabilities can simply be defined as the amount that the company owes to its suppliers, in exchange of goods (or services) that have already been provided for but not yet paid for. Liabilities can be regarded as obligations that need to be honored by the company in order to settle the respective accounts.

Equity Component of the Accounting Equation

This transaction affects both sides of the accounting equation; both the left and right sides of the equation increase by +$250. The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left-side value of the equation will always match the right-side value. The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet.

Therefore, the accounting equation can be explained as the basic accounting formula, or what is standard cost its an estimate the premise by which the business functions or operates. Therefore, it is absolutely necessary to have a proper understanding of the accounting equation, the components, as well as the formula in order to understand how basic accounting works. Now that you are familiar with some basic concepts of the accounting equation and balance sheet let’s explore some practice examples you can try for yourself. In accounting, we have different classifications of assets and liabilities because we need to determine how we report them on the balance sheet. The first classification we should introduce is current vs. non-current assets or liabilities. Obligations owed to other companies and people are considered liabilities and can be categorized as current and long-term liabilities.