Explain the Basic Accounting Equation: Understanding the Relationship between Assets, Liabilities, and Equity

Assets are resources that a company owns and can use to generate future economic benefits. Liabilities are obligations that a company owes to others, Insurance Accounting such as loans or accounts payable. Equity represents the residual interest in the assets of the company after deducting liabilities. For sole proprietorships, the accounting equation is used to determine the owner’s equity. This is important because it helps the owner to understand the financial position of their business and make informed decisions about its future. Liabilities refer to the obligations that a company owes to others and are expected to be settled in the future.

Current Assets

• Rather, transactions are recorded into specific accounts contained in the company’s general ledger.
• It is used to ensure that financial transactions are recorded accurately and that the financial statements produced are accurate.
• If the revenues earned are a main activity of the business, they are considered to be operating revenues.
• When you “expense” something, you debit it, because it’s a decrease to equity.
• A credit in contrast refers to a decrease in an asset or an increase in a liability or shareholders’ equity.
• We know that every business holds some properties known as assets.

However, most accounting references to assets relate to business (not personal) assets. Individuals also aim to accumulate assets over their lifetime in the form of wealth, investments, bank and retirement accounts, cars, homes, and even the asset of education. First, Let’s discuss the definitions of each component of the accounting equation. For every decrease in assets, there is a corresponding decrease in liabilities or equity. I’m a CPA, and it took me several years to fully understand the WHY behind the accounting equation. Follow along with this tutorial, and I think it’ll sink in for you, too.

Explain the Basic Accounting Equation: Understanding the Relationship between Assets, Liabilities, and Equity

The double-entry system requires a company’s transactions to be entered/recorded in two (or more) general ledger accounts. One account will have the amount entered on the left-side (a debit entry), while another account will have the amount entered on the right-side (a credit entry). As a result, the total amount of debits in the accounts will be equal to the total amount of credits in the accounts. This will be evidenced by the accounting equation and the company’s balance sheet. Examples of assets include cash, accounts receivable, inventory, and property, plant, and equipment. Examples of liabilities include accounts payable, loans, and taxes owed.

Income Statement

The term capital includes the capital introduced by the business owner plus or minus any profits or losses made by the business. Profits retained in the business will increase capital and losses will decrease capital. The accounting equation will always balance because the dual aspect of accounting for income and expenses will result in equal increases or decreases to assets or liabilities. In conclusion, the basic accounting equation is the foundation of financial statements. The balance sheet and income statement provide important information about a company’s financial position and performance.

In short, assets are the “stuff” a business owns, and liabilities and equity are the rights to that stuff by outsiders and insiders. This transaction affects only the assets of the equation; therefore there is no corresponding effect in liabilities or shareholder’s equity on the right side of the equation. Equity represents the owners’ residual interest in the business after liabilities are deducted from assets. A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold. The inventory of a manufacturer should report the cost explain the accounting equation and what makes up each part. of its raw materials, work-in-process, and finished goods.

For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com. When inventory items are acquired or produced at varying costs, the company will what are retained earnings need to make an assumption on how to flow the changing costs. That will be followed by looking at similar transactions at a corporation. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Accounting measures a business’s health by examining the value of assets, the rights to those assets, and the inflows and outflows of assets.

The totals show us that the corporation had assets of $17,200 with $7,120 provided by the creditors and $10,080 provided by the stockholders. The accounting equation also reveals that the corporation’s creditors had a claim of $7,120 and the stockholders had a residual claim for the remaining $10,080. The accounting cycle is the process by which a company records and reports its financial transactions. It includes several steps, such as journalizing transactions, posting to the general ledger, preparing trial balances, and creating financial statements. The accounting equation is used throughout the accounting cycle to ensure that the financial statements accurately reflect the financial position of the company.

Strengthening Financial Management with the Accounting Equation

Speakers, Inc. purchases a $500,000 building by paying $100,000 in cash and taking out a $400,000 mortgage. This business transaction decreases assets by the $100,000 of cash disbursed, increases assets by the new $500,000 building, and increases liabilities by the new $400,000 mortgage. As you can see, assets equal the sum of liabilities and owner’s equity. This makes sense when you think about it because liabilities and equity are essentially just sources of funding for companies to purchase assets. The accounting equation ensures that the balance sheet remains balanced.