Accounting Equation Overview, Formula, and Examples

For a company keeping accurate accounts, every business transaction will be represented in at least two of its accounts. For instance, if a business takes a loan from a bank, the borrowed money will be reflected in its balance sheet as both an increase in the company’s assets and an increase in its loan liability. When the total assets of a business increase, then its total liabilities or owner’s equity also increase. The accounting equation’s left side represents everything a business has (assets), and the right side shows what a business owes to creditors and owners (liabilities and equity).

The accounting equation, also called the balance sheet equation, was built on the premise that for every asset that a business owns, there is a claim against that asset in the form of a liability or owner’s equity. An error in transaction analysis could result in incorrect financial statements. An accounting transaction is a business activity or event that causes a measurable change in the accounting equation. the accounting equation is usually expressed as Merely placing an order for goods is not a recordable transaction because no exchange has taken place. In the coming sections, you will learn more about the different kinds of financial statements accountants generate for businesses. The income and retained earnings of the accounting equation is also an essential component in computing, understanding, and analyzing a firm’s income statement.

How to calculate assets in accounting?

Mr Ram, a sole proprietor has the following transactions in his books of accounts for the year 2019. This equation reveals the value of assets owned purely by owner equity. The ingredients of this equation – Assets, Liabilities, and Owner’s equities are the three major sections of the Balance sheet. By using the above equation, the bookkeepers and accountants ensure that the “balance” always holds i.e., both sides of the equation are always equal.

Like any brand new business, it has no assets, liabilities, or equity at the start, which means that its accounting equation will have zero on both sides. In this form, it is easier to highlight the relationship between shareholder’s equity and debt (liabilities). As you can see, shareholder’s equity is the remainder after liabilities have been subtracted from assets. This is because creditors – parties that lend money such as banks – have the first claim to a company’s assets. This equation sets the foundation of double-entry accounting, also known as double-entry bookkeeping, and highlights the structure of the balance sheet. Double-entry accounting is a system where every transaction affects at least two accounts.

Double entry bookkeeping system

If you’re still unsure why the accounting equation just has to balance, the following example shows how the accounting equation remains in balance even after the effects of several transactions are accounted for. The accounting equation shows the amount of resources available to a business on the left side (Assets) and those who have a claim on those resources on the right side (Liabilities + Equity). Today’s accounting software applications have the accounting equation built into the application, rejecting any entries that do not balance. This can be useful for those new to accounting, since any entry into your general ledger will directly affect your accounting equation.

• Debt is a liability, whether it is a long-term loan or a bill that is due to be paid.
• The inventory purchase affected the inventory account under assets and the accounts payable account under liabilities.
• The accounting equation connotes two equations that are basic and core to accrual accounting and double-entry accounting system.
• The accounting equation describes the relationship that exists between the assets and liabilities of a company, in addition to the owner’s equity.
• The accounting equation plays a significant role as the foundation of the double-entry bookkeeping system.

Firms can get the data for total assets and total liabilities from the balance sheet which they can then use further in the accounting equation to determine the equity. As expected, the sum of liabilities and equity is equal to $9350, matching the total value of assets. So, as long as you account for everything correctly, the accounting equation will always balance no matter how many transactions are involved. Using the numbers from the Edelweiss Corporation’s balance sheet, we can see the accounting equation has been properly used, with assets equal to total liabilities plus equity.