Accounting Equation

As the foundation of the double-entry accounting system, the accounting equation is an accounting tool used to measure the assets, liabilities, and equity of a business entity (assets = liabilities + equity, or owner’s equity). It reveals the relationship that exists among the elements of the equation. An asset is an economic resource that a business owns that is expected to provide future benefits. Some examples of assets include cash and accounts receivable, which is a right to collect cash from a customer in the future, resulting from services provided or products bought on credit. Products may include supplies, inventory, and land. A liability is an obligation or amount owed to another individual or entity as a result of a past transaction. Some examples of liabilities include accounts payable, liabilities that result from purchases of goods or services on account. They can include unearned revenue, interest payable, taxes payable, and notes payable. Equity is the owner's right to the resources of the business. It is the difference between the value of the business’s assets and the value of its liabilities.

The accounting equation is most often expressed as Assets = Liabilities + Equity (also called owner's equity). The accounting equation should always balance, meaning the left side of the equation should always equal the right side of the equation. A business transaction affects or changes the entity’s financial condition. Business transactions impact the accounting equation by increasing or decreasing two or more elements in the equation. When recording business transactions, the first step is to identify the accounts and types of accounts involved. The next step is to determine the impact of the transaction on each account; the account either increased or decreased because of the transaction. Finally, the steps are brought together, and the accounting equation balance is calculated. Importantly, the accounting equation must balance after we are done processing each business transaction.

For example, David Baxter opens a music store. He borrows $10,000 and gives the business $5,000 of his own cash. This transaction is represented in the accounting equation as assets of $15,000 equals liabilities of $10,000 plus equity of $5,000. As the company has $15,000 cash, it could begin to use that cash to purchase instruments for its inventory.