The accounting equation is used in financial accounting, which defines the relationship between a firm’s assets, liabilities, and shareholders’ equity. As per the accounting equation, the relationship between these terms can be represented as follows:
Assets = Liabilities + Shareholders’ equity
It means that a firm’s total assets will always be equal to the sum of total liabilities and shareholders’ equity.
This can further be explained with an example.
Let us suppose that Company ABC starts a business with $10,000 cash, and $15,000 equipment. At the start of the business, the firm is having $25,000 of total assets ($10,000 + $15,000) and shareholders’ equity of $25,000 (The amount invested by the owner). The accounting equation will look like as follows:
$25,000 (Assets) = $0 (liabilities) + $25,000 (Shareholders’ equity)
Suppose the firm purchases $8,000 merchandise inventory on account. It will increase the assets by $8,000 (because of merchandise inventory) and increase the accounts payable by the same amount. Now, the accounting equation will look like as follows:
$33,000 (assets) = $8,000 (Liabilities in the form of accounts payable) + $25,000 (Shareholders’ equity)
Next, we assume that the firm pays half of the accounts payable. It will reduce the accounts payable by $4,000 and reduce the cash balance by the same amount. The accounting equation will appear as follows:
$29,000 (assets) = $4,000 (Liabilities in the form of accounts payable) + $25,000 (Shareholders’ equity)
Therefore, each financial transaction of a business will affect the accounting equation, however, it will always remain balanced.
