Accounting equation

The most basic principle in accounting is the accounting equation. It states that Assets = Liabilities + Owner’s Equity. This equation is the backbone of the double-entry accounting system.

Components of the Accounting Equation:

Assets: An asset is a resource owned by a business which is expected to produce future benefits. Assets can be tangible (like buildings, cash, inventories) or intangible (like patents, goodwill).
Liabilities: A liability is a financial obligation the business owes to an external party (such as a creditor, bank, or supplier). Liabilities might include loans, accounts payable, mortgages, deferred revenues, or accrued expenses.
Owner’s Equity: Also known as capital or net worth, it represents the owner’s claims on the business assets. It includes initial investment, any additional investments, and retained earnings (profits kept within the business).

Importance of the Accounting Equation

The accounting equation keeps the company’s accounts balanced, ensuring every financial transaction has equal and opposite effects in at least two different accounts.
It ensures the company’s financial statements are always in balance and integrity of the financial information is maintained.
Being a fundamental principle of accounting, the understanding of the accounting equation is essential to grasp how businesses record financial information for reporting purposes.

Applications of the Accounting Equation

When a business transaction occurs, it affects at least two accounts, and the accounting equation ensures that the company’s accounts will always balance.
In the double-entry bookkeeping, each accounting entry debits one account and credits another: if an asset account increases (a debit entry), then either another asset account decreases (a credit entry), or a liability or equity account increases (a credit entry).
Any increase in expense will reduce owner’s equity and vice-versa. Conversely, an increase in revenue will increase owner’s equity.

Remember, the accounting equation acts as a error detection tool; if at any point the sum of debits for all accounts does not equal the credits, it indicates an error has occurred in the recording of the transactions.