The accounting equation, also known as the balance sheet equation, is a fundamental principle in accounting that represents the relationship between a companys assets, liabilities, and owners equity. It is the foundation for the double-entry bookkeeping system, which is used to record financial transactions. The equation states that a companys total assets are equal to the sum of its liabilities and its shareholders equity. This means that what the company owns (its assets) has been purchased with equity and/or liabilities. The accounting equation ensures that all entries in the books and records are vetted, and a verifiable relationship exists between each liability (or expense) and its corresponding source, or between each item of income (or asset) and its source. The equation can be expressed as follows:
Assets = Liabilities + Owners Equity
- Assets: These are the valuable resources controlled by a company, such as cash, inventory, property, and equipment.
- Liabilities: These represent the companys obligations, such as loans, accounts payable, and taxes owed.
- Owners Equity: This represents the amount of money that the companys owners have invested in the business, plus any profits that the company has retained.
The accounting equation is used to prepare a companys balance sheet, which is one of the most important financial statements in a business. The balance sheet shows all that the business owns, all debts and obligations, and what owners have invested in the company. The accounting equation ensures that the balance sheet is balanced, meaning that the left side (assets) should always equal the right side (liabilities + owners equity) .
