Accounting Basic: What is the Accounting Equation? - Finance - Accounting

The accounting equation is the basic, fundamental formula of double-entry accounting. The formula of the accounting equation involves a businesss liabilities, assets, and equity and how these three elements are related. The formula says that a businesss equity, or net worth, can be calculated by subtracting the worth of the businesss liabilities from the worth of its assets.

The accounting equation is the most commonly used equation on accounting balance sheets, and it is necessary to understand the accounting equation in order to properly evaluate and understand an accounting balance sheet.

With a basic understanding of the terms associated with the accounting equation, it is relatively easy to understand the formula and how it works. The worth of a businesss liabilities is the total amount of money or resources the business paid out in order to acquire its assets. The worth of a businesss 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's Cellular Phones. Last month the following transactions took place:

The accounting 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 businesss assets and liabilities, such as depreciation, that can fluctuate over time.

The accounting equation works not only to accurately assess the equity of a business, but also to alert a business to problems regarding the calculation of its equity. If the accounting equation is properly used and the liabilities are accurately subtracted for the assets, the calculated equity should match the actual equity. If there is a discrepancy between what the accounting equation calculates as a companys equity and the actual equity, then there is clearly a problem that should be investigated. Or, if the sum of the worth of liabilities and the worth of the equity does not equal the worth of assets, there is an accounting error. Thus, a discrepancy can alert businesses to a problem with their accounting balance sheet.

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