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 equity. The equation is expressed as follows:
Assets = Liabilities + Equity
This equation shows that a companys total assets must be equal to the sum of its liabilities and equity. Assets represent the valuable resources controlled by the company, while liabilities represent their obligations. Equity represents the residual interest in the assets of the company after deducting liabilities.
The accounting equation is considered to be the foundation of the double-entry accounting system. In a double-entry accounting system, every transaction affects at least two accounts, and 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 accounting equation is used to transfer totals from books of prime entry into the nominal ledger. It is also used to keep track of debits and credits and ensure that the sum of these always matches up to the company assets, a calculation carried out by the accounting equation. Due to its role in determining a firms net worth, the accounting equation is an important tool for investors looking to measure a companys holdings and debts.
