Accounting Equation

Accounting Equation

Assets = Equity + Liabilities

The accounting equation is the basis of all the accounting. This equation says Assets equal Equity plus Liabilities. In other words, What I have is equal to what I owe plus what I own.

One of the financial statements – a Balance Sheet – is prepared based on this principle. The reason for calling it balance sheet is that always the left-hand side equals the right-hand side – they are balanced.

It is actually simple logic. Whatever you want to buy (What I have), either you can use your own money (What I own) or you can take a loan to buy it (What I owe).

Let’s take an example of a food processing company buying the spray drying machine worth $10,000 for its operations. The bank has sanctioned the loan of $5,000 to the company for buying this machine. Another $5000, is invested by the owner of the company. Now how does this particular transaction reflect in the company’s balance sheet based on the accounting equation?

  • Spray drying machine worth $10,000 reflects in the Assets of the company
  • A company using its own money of $5,000 reflects in the equity and
  • Company liable for the bank to pay $5,000 reflects in the liability
  • The total of the Left-hand side equals the total of the right-hand side

Depending on the size and nature of the business, many such transactions will happen on a daily basis and will be recorded.