Accounting Equation: Definition, Formula & Examples

A liability, in its simplest terms, is an amount of money owed to another person or organization. Said a different way, liabilities are creditors’ claims on company assets because this is the amount of assets creditors would own if the company liquidated. Now that we have a basic understanding of the equation, let’s take a look at each accounting equation component starting with the assets.

Assets represent the valuable resources controlled by a company, while liabilities represent its obligations. Both liabilities and shareholders‘ equity represent how the assets of a company are financed. If it’s financed through debt, it’ll show as a liability, but if it’s financed through issuing equity shares to investors, it’ll show in shareholders‘ accounting formula equity. As we previously mentioned, the accounting equation is the same for all businesses. It’s extremely important for businesses in that it provides the basis for calculating various financial ratios, as well as for creating financial statements. The owner’s equity is the share the owner has on these assets, such as personal investments or drawings.

The expanded version of the accounting equation

An error in transaction analysis could result in incorrect financial statements. As you can see, assets equal the sum of liabilities and owner’s equity. This makes sense when you think about it because liabilities https://www.bookstime.com/ and equity are essentially just sources of funding for companies to purchase assets. To prepare the balance sheet and other financial statements, you have to first choose an accounting system.

• For example, if one asset increases by $5,000, it’s possible that another asset will decrease by $3,000, and liabilities will increase by $2,000 simultaneously.
• A company’s resources that it owns are referred to as its assets.
• The Accounting Equation serves as a valuable tool in financial analysis, enabling analysts to evaluate a company’s financial health and stability.
• Although Coca-Cola and your local fitness center may be as different as chalk and cheese, they do have one thing in common – and that’s their accounting equation.
• While we mainly discuss only the BS in this article, the IS shows a company’s revenue and expenses and goes down to net income as the final line on the statement.

If we had used the owner’s personal bank account to buy the iPhone, then our owner’s equity on the credit side would have increased. The Accounting Equation is based on the double entry accounting, which says that every transaction has two aspects, debit and credit, and for every debit there is equal and opposite credit. It helps to prepare a balance sheet, so it is also called the Balance Sheet Equation. Creditors and owners can both stake a claim on the assets of a company. In order to determine what belongs to the owners, we first take the claims that the creditors have (which are liabilities) and subtract those from the assets. The amount that is left over is what is known as the owner’s equity in the assets.

Applying the Accounting Equation in Business Decision Making

Use the balance sheet equation when setting your budget or when making financial decisions. Company credit cards, rent, and taxes to be paid are all liabilities. Do not include taxes you have already paid in your liabilities. This reduces the cash (Asset) account and reduces the retained earnings (Equity) account. (1) as claims by creditors against the company’s assets, and
(2) as sources (along with owner’s or stockholders‘ equity) of the company’s assets.

• Accounts receivable list the amounts of money owed to the company by its customers for the sale of its products.
• An Accounting Equation is also called the Balance Sheet Equation.
• Well, this time we’ll be using the bank again, only now we’ll be spending money.
• Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
• The asset, liability, and shareholders’ equity portions of the accounting equation are explained further below, noting the different accounts that may be included in each one.