What is the accounting equation?

The accounting equation represents the basic equation associated with double-entry accounting. Essentially, the accounting equation establishes the formula to represent the relationship that exists between assets, liabilities and equity. As the most common of all balance sheet equations, the accounting equation is also critical to learning to read and correctly use a balance sheet.

To understand how the accounting equation works, it is important to have an idea of ​​what each of the three basic components mentioned in the equation means. Assets refer to the value of goods or products in the owner's possession. Liabilities represent the amount of cash or funds that were borrowed to acquire the assets. Equity is the financial wealth of the individual, less outstanding debts to external entities. Essentially, the purpose of the accounting equation is to arrive at that final component of equity, or as it is sometimes called, equity.

To illustrate how the accounting equation for determining equity works, suppose an investor currently has an equity of $2,000, with no current liabilities. The owner chooses to acquire a new asset for the value of one thousand dollars. To acquire the property, the owner chose to use five hundred dollars of property already in his possession and then borrow five hundred dollars to complete the purchase. Assuming that there is no depreciation associated with the acquired asset, the owner gains control of assets worth a total of three thousand US dollars (USD). However, he now has liabilities worth five hundred dollars. This will result in a net worth of two and a half thousand dollars. As long as the sum of equity and liabilities equals assets, all is well in the accounting process.

Simply speaking, the accounting equation illustrates that equity is determined by taking the value of available current assets and subtracting the value of any current liabilities. When it comes to using the accounting equation as the basic balance sheet equation, this means that the bottom line of the balance sheet will always show the net worth of the person or entity. As long as the final value of equity and the value of liabilities balances out with assets, everything will be fine. However, if the combination of liabilities and equity does not equal total assets, there is something wrong with the accounting process, and an investigation to discover the source of the imbalance must be carried out immediately.

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