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The basic accounting equation is the foundation for the double-entry bookkeeping system. It shows how assets were financed: either by borrowing money from someone (liability) or by paying your own money (shareholders' equity).From the large, multi-national corporation down to the family owned restaurant, every business transaction will have an effect on a company's financial position. The financial position of a company is measured by the following items:
1. Assets (what it owns)
2. Liabilities (what it owes to others)
3. Owner's Equity (the difference between assets and liabilities)
The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is:
Assets = Liabilities + Owner's Equity
The accounting equation for a corporation is:
Assets = Liabilities + Stockholders' Equity
Assets are a company's resources, everything of value that is owned by a person or company. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, copyrights, patents, trademarks and goodwill. From the accounting equation, we see that the amount of assets must always equal the combined amount of liabilities plus owner's (or stockholders') equity.
Liabilities are a company's obligations arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. In simple words it includes all amounts that the company owes to others. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable.
Owner's or stockholders' equity reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners. It can also be defined as the amount left over after liabilities are deducted from assets.
If a company keeps accurate records, the accounting equation will always be 'in balance,' meaning the left side should always equal the right side. The balance is
maintained because every business transaction affects at least two of a company's accounts. For example, when a company borrows money from a bank, the company's assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double entry accounting.