The accounting equation is the basic, fundamental formula of double-entry system. The formula of the equation involves a business’s liabilities, assets, and equity and how these three elements are related. The formula says that a business’s equity, or net worth, can be calculated by subtracting the worth of the business’s liabilities from the worth of its assets.
The accounting equation is the most commonly used equation on balance sheets, and it is necessary to understand the equation in order to properly evaluate and understand balance sheet.
With a basic understanding of the terms associated with the equation, it is relatively easy to understand the formula and how it works. The worth of a business’s liabilities is the total amount of money or resources the business paid out in order to acquire its assets. The worth of a business’s assets is the total amount of money or products in possession of the business owner. The accounting equation is represented: worth of assets – worth of liabilities = total equity.
For an example of the accounting equation let us consider ABC Cellular Phones. Last month the following transactions took place:
the owner invested $3,000 into his business
paid $500 for his bills for the month
received $1,000 from customer for purchases.
The equation would look like this:
assets ($3,000 + $1,000) – liabilities ($500) = $3,500 total equity.
It is important to understand that this illustration is very basic and does not take into consideration factors that influence the worth of business’s assets and liabilities, such as depreciation, that can fluctuate over time.
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