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What is accounting equation?

The accounting equation, also known as the basic accounting equation or the balance sheet equation, is a fundamental concept in accounting that represents the relationship between a company’s assets, liabilities, and equity. It can be expressed as:

Assets = Liabilities + Equity

Here’s a breakdown of each component:

1. Assets: Assets are economic resources owned or controlled by a company that have measurable value. Examples of assets include cash, accounts receivable, inventory, property, plant, and equipment. Assets represent what a company owns or has a claim to.

2. Liabilities: Liabilities are the financial obligations or debts owed by a company to external parties. They represent the claims of creditors against the company’s assets. Examples of liabilities include accounts payable, loans, accrued expenses, and deferred revenues.

3. Equity: Equity, also referred to as shareholders’ equity or owner’s equity, represents the residual interest in the assets of a company after deducting liabilities. It represents the ownership interest or the net worth of the owners in the business. Equity can be divided into various components, such as contributed capital, retained earnings, and accumulated other comprehensive income.

The accounting equation demonstrates that the total assets of a company must always be equal to the sum of its liabilities and equity. It reflects the concept that a company’s assets are funded either by liabilities (borrowed funds) or by the owners’ investment (equity).

The equation remains in balance as financial transactions occur. For example, if a company borrows $10,000 from a bank, the assets will increase by $10,000 (cash) and liabilities will increase by $10,000 (loan payable), maintaining the equality of the equation.

The accounting equation serves as the foundation for double-entry bookkeeping, which is the system used to record and track financial transactions. It ensures that every transaction affects the equation by maintaining the balance between assets, liabilities, and equity.