The accounting equation is utilized when conducting double entry accounting. In double entry accounting, there is always at least one debit and one credit. Significantly, debits must equal credits. Thus, the accounting equation is Assets = Liabilities + Equity. It is important to utilize this information in order to ensure that the company’s financial position is accurately shown. This equation is fundamental to double entry accounting because assets are typically debits, whereas liabilities and equity are typically credits. For assets, debits increase the account and credits decrease the account. For liabilities and equity, debits decrease the account and credits increase the accounts. The only difference to these normal transactions is through contra accounts. Therefore, assets refer to what the company owns. Liabilities refer to what the company owes. Equity refers to the difference between assets and liabilities.
On the balance sheet, assets are typically displayed on one side, while liabilities and equity are typically placed on the other side. Once all financial information is journalized and posted, the total of assets must equal the total of liabilities and equity. In other words, the left side must always equal the right side of the balance sheet.
Use your promo and get a custom paper on
"Accounting Equation".
The following provides a simple transaction designed to illustrate the accounting equation:
| Assets | = | Liabilities | + | Equity |
| Cash | = | Equity | ||
| $10,000 | = | $10,000 |
As the example shows, assets equal liabilities plus equity. In this case, the owner invested in the business. Therefore the asset (Cash) was debited and the equity (Equity) was credited. As such, the accounting equation is in balance.
The following provides a more complex transaction designed to illustrate the accounting equation:
| Assets | = | Liabilities (+ Equity) | ||||
| Building | + | Land | – | Cash | = | Payables |
| $10,000 | + | $15,000 | – | $5,000 | = | $20,000 |
In this transaction, the owner has purchased a building and land worth $25,000 (calculated as $10,000+$15,000). The owner paid $5,000 in cash upon purchase and the rest was purchased on credit. Thus, the asset (building) would be debited to show an increase in holdings. The asset (land) would be debited to show an increase in holdings. The asset (cash) would be credited to show that money was paid towards the purchase. The liability (payables) would be credited to show that the remainder of the purchase was placed on credit.
