What is the accounting equation?
submitted by MDoran

stephen_21

Assets = Liabilities + Equity

Mark Stephens

Assets = Liabilities + Equity.

This is basically the foundation of all accounting. If you think about it, accounting is about keeping an account of all financial activity in an organization. This equation is a quick overview of the biggest elements of that activity. It's a fast way to see what's owned and what's owed.

For the accounting students out there: Assets are what the company owns. That's cash, inventory, property, equipment. Liabilities are what it owes to outside parties. That's loans, accounts payable, etc. Equity is what the owners can claim after all the debts are paid off. All together, you're looking at the net worth of the company.

If a company wants to increase assets, this equation shows you that they've either got to borrow money (liabilities) or increases owner’s equity. The latter could be done through retained earnings from prior years or adding new investments.

This equation is also the basis for double-entry bookkeeping. It requires that you have two entries on every transaction, because it keeps the equation balanced. So, technically assets, liabilities, and equity are all interconnected pieces of the same puzzle.

Tom J

It's what makes double entry bookkeeping what it is. When a company takes out a loan, liabilities increase, but so do assets (because you've got more cash). When the company earns a profit, that increases equity (through retained earnings), which can be used to purchase more assets. The three factors are all related, so they've got to stay balanced.

You can use the accounting equation as the vital signs of a business. Let's say a company has a high ratio of liabilities to assets. You could look at that as a higher financial risk, whereas a strong equity position indicates it's a bit more stable. So, despite this being a simple equation, you can get a quick idea of a company by looking at this alone.