The Accounting Equation

Every business transaction, from the largest multi-national conglomerate to the corner beauty boutique, has an impact on a company’s financial status. The following items are used to assess a company’s financial position:

Possessions (what it owns)
Responsibilities (what it owes to others)
Ownership Equity (the difference between assets and liabilities)

The accounting equation (or fundamental accounting equation) provides a straightforward explanation of how these three quantities relate to one another. A lone proprietorship’s accounting equation is:


The accounting equation for a corporation is:


Assets are a company’s resources—the stuff it owns. Cash accounts receivable, inventories, prepaid insurance, investments, land, buildings, equipment, and goodwill are all examples of assets. According to the accounting equation, the total quantity of assets must equal the total number of liabilities plus the amount of owner’s (or shareholders’) equity.

Liabilities are a company’s obligations—the money it owes. Notes or loans payable, accounts payable, salaries and wages payable, interest payment, and income taxes payable are all examples of liabilities (if the company is a regular corporation). There are two ways to look about liabilities:

(1) as claims by creditors against the company’s assets, and (2) as a source of the company’s assets (together with owner or shareholder equity).

Owner’s equity, also known as shareholders’ equity, is the amount left over after obligations have been removed.

Assets – Liabilities = Owner’s (or Stockholders’) Equity.

Owner’s or stockholders’ equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.

If a company keeps accurate records, the accounting equation will always be “in balance,” meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of a company’s accounts. For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double-entry accounting.

A company keeps track of all of its transactions by recording them in accounts in the company’s general ledger. Each account in the general ledger is designated as its type: asset, liability, owner’s equity, revenue, expense, gain, or loss account.

Balance Sheet and Income Statement

The balance sheet is also known as the statement of financial position and it reflects the accounting equation. The balance sheet reports a company’s assets, liabilities, and owner’s (or stockholders’) equity at a specific point in time. It demonstrates, like the accounting equation, that a company’s total assets equal the total liabilities plus the owner’s (or shareholders’) equity.

The income statement is a financial statement that shows a company’s sales, costs, and net income. The balance sheet is concerned with a single moment in time, whereas the income statement is concerned with a time interval or period of time.

The income statement will explain part of the change in the owner’s or stockholders’ equity during the time interval between two balance sheets.

Also read: What are Debits and Credits?

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