The Accounting Equation

Every transaction that happens within a business has an effect on its financial position. The accounting equation is what keeps all of the transactions in balance and helps users of the information make sense of what areas each transaction affects. The financial position of any company is based on the following items:

  • Assets: what the company owns
  • Liabilities: what the company owes to other parties
  • Owners’ Equity: the difference between assets and liabilities

The Accounting Equation

The basic accounting equation simplifies our understanding of how these three areas of the company relate to each other. The basic accounting equation for any given business is:

Assets = Liabilities + Owners’ Equity

Assets are the things that the company owns, or its resources. Assets are things like cash, accounts receivable, inventory, prepaid insurance, buildings & equipment, land, and goodwill. Remember that total assets will always equal liabilities + owners’ equity. That’s exactly what a balance sheet means… because the assets, or the left side of the balance sheet, will always equal liabilities + owners’ equity, or the right side of the balance sheet.

Liabilities are the company’s obligations, or the amounts that the company still has to repay to other parties. Liabilities can be notes payable, accounts payable, wages payable, interest payable, bonds payable, or income taxes payable. Liabilities can be viewed as bills that the company has to pay, or as the part of the source of acquiring their assets. For example, if the company bought a new delivery truck for $20,000 using a $20,000 loan from the bank, then the company has an asset of $20,000, as well as a liability of $20,000 to pay back to the bank. Notice that the asset equals the liability in this example.

Owners’ equity is the amounts invested by the owners of the company plus the cumulative net income that hasn’t been taken out or distributed as dividends to the owners of the company.


Difference Between the Balance Sheet and the Income Statement

As we already mentioned, the balance sheet is called the balance sheet because the accounting equation will always balance… meaning the assets side of the balance sheet will always equal the same as the liabilities + owners’ equity. There is also a big difference in the format of the balance sheet versus the income statement. The balance sheet gives a company’s financial position at any given point in time, where as the income statement is a report of activities over a given time period.

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