The Accounting Equation

From the large, multi-national corporation down to the small shops, every business transaction will have an effect on a company’s financial position. The financial position of a company is measured by the following items:

1. Assets (what it owns)

2. Liabilities (what it owes to others)

3. Owner’s Equity (the difference between assets and liabilities)

The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is:

 

Assets = Liabilities + Owner’s Equity

 

The accounting equation for a corporation is:

Assets = Liabilities + Stockholders’ Equity

Assets are a company’s resources, the things that the company owns. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner’s (or stockholders’) equity.

Liabilities are a company’s obligations, the amounts the company owes to others. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways:

(1) as claims by creditors against the company’s assets, and

(2) a source—along with owner or stockholder equity—of the company’s assets.

 

Owner’s equity or stockholders’ equity is the amount left over after liabilities are deducted from assets:

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the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.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 to its type: asset, liability, owner’s equity, revenue, expense, gain, or loss account.