In last week’s blog post about double-entry bookkeeping, we mentioned the accounting equation. But what exactly is it and what does it tell you?
What is the Accounting Equation?
Also known as the basic accounting equation, the basic accounting formula, and the balance sheet equation, the accounting equation is:
Assets = Liabilities + Owners’ Equity
The accounting equation is considered the foundation of double-entry bookkeeping, where every transaction gets recorded as a debit in one account and a credit in another. The equation should always be balanced since assets are either purchased with liabilities or equity. An unbalanced equation could be the result of an arithmetic error, something being entered incorrectly, or not entering a credit/debit for a transaction.
Let’s break down this equation a little more.
Assets
An asset is a resource (tangible or intangible) that is owned by your company and provides positive economic value. Tangible assets include cash, accounts receivables, inventory, supplies, vehicles, and land. Intangible assets include patents, copyrights, and trademarks. Activities such as purchasing assets or recording sales will increase your asset account.
Liabilities
Liabilities are the existing obligations and debt that your company owes. This includes bank loans, accounts payable, wages payable, rent, utilities, and taxes. Anytime you take out a loan or receive a bill, your liabilities will increase. For example, taking out a loan will increase both your assets (cash) and liabilities (loan) by the same amount, keeping the equation balanced.
Owners’ Equity
Owners' equity represents what you (and other owners and stockholders) have invested into the business. It can also be seen as your revenue after all debts have been paid. If you rearrange the formula, you can determine owners’ equity.
Owners’ equity = Assets - Liabilities
What Does the Accounting Equation tell you?
The accounting equation can help you see the relationship between your assets, liabilities, and owners’ equity. It ensures that the balance sheet is balanced and helps you detect possible errors in your recordkeeping. However, it doesn’t provide enough data to determine how well your business is performing. Rather, it provides the foundation to balance your accounts and create financial statements to understand the financial position of your business.
Do you need help recording your transactions and keeping your accounts balanced? Our team of experienced bookkeepers is currently taking on new clients. Contact us here or give us a call at (360) 671-0244 to see how we can best fit your needs.