What is the Accounting Equation?
The Accounting Equation is a fundamental principle stating that a company’s assets (i.e. resources) must always be equal to the sum of its liabilities and equity (i.e. funding sources).
Accounting Equation: Assets = Liabilities + Equity
The chart below summarizes the accounting equation:
Balance Sheet Equation: Fundamental Concepts
The balance sheet is one of the three main financial statements that depicts a company’s assets, liabilities, and equity sections at a specific point in time (i.e. a “snapshot”).
Typically reported on a quarterly or annual basis, the balance sheet consists of three components:
- The resources with economic value which can be sold for money post-liquidation or are anticipated to bring positive monetary benefits in the future.
- The unsettled future obligations to a third party that represent economic costs (i.e. the external sources of capital from third parties that helped fund the company’s purchase of assets).
|Shareholders’ Equity Section
- The internal sources of capital that helped fund its assets, such as capital invested by the founders and issuances of equity financing.
Accounting Equation Formula
The fundamental accounting equation, as mentioned earlier, is as follows:
Total Assets = Total Liabilities + Total Shareholders’ Equity
The rationale is that the assets belonging to a company must have been funded somehow, i.e. the money used to purchase the assets did not just appear out of thin air to state the obvious.
If a company’s assets were hypothetically liquidated (i.e. the difference between assets and liabilities), the remaining value is the shareholders’ equity account.
Therefore, the assets side must always be equal to the sum of the liabilities and equity — which are the company’s two funding sources:
- Liabilities — e.g. Accounts Payable, Accrued Expenses, Debt Financing
- Shareholders’ Equity — e.g. Common Stock and APIC, Retained Earnings
Double Entry Accounting System: Journal Entry (Debits and Credits)
The accounting equation sets the foundation of “double-entry” accounting since it shows a company’s asset purchases and how they were financed (i.e. the off-setting entries).
A company’s “uses” of capital (i.e. the purchase of its assets) should be equivalent to its “sources” of capital (i.e. debt, equity).
In all financial statements, the balance sheet should always remain in balance.
Under the double-entry accounting system, each recorded financial transaction results in adjustments to a minimum of two different accounts.
On the accounting ledger, there are two entries recorded for bookkeeping purposes:
- Debits — An entry on the left side of the ledger
- Credits — An entry on the right side of the ledger
Each entry on the debit side must have a corresponding entry on the credit side (and vice versa), which ensures the accounting equation remains true.
For all recorded transactions, if the total debits and credits for a transaction are equal, then the result is that the company’s assets are equal to the sum of its liabilities and equity.