# Accounting Equation - Explained

What is the Accounting Equation?

# What is the Accounting Equation?

Assets = Liabilities + Equity

The accounting equation, also known as the fundamental accounting equation or a balance sheet equation, is a principle of accounting that establishes a correlation between assets, liabilities and equity of an individual or a business entity.

An accounting equation is a principal component of the double-entry accounting system and forms part of a balance sheet.

The accounting equation states that the total assets of the individual or the business equals the sum of the liabilities and equity. In the case of an individual, the total assets equal the sum of liabilities and owners equity, whereas in the case of a company, the sum of assets equals the sum of liabilities and stockholders equity.

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## Explaining the Accounting Equation

Mathematically, an accounting equation can be represented as:

Assets = Liabilities + Equity

or,

Assets = Liabilities + Owners Equity (for individuals or sole proprietors)

Assets = Liabilities + Stockholders Equity (for companies).

Let us now individually inspect the components of the accounting equation.

## Components of the Accounting Equation

Assets: Assets typically consist of the following;

• Cash
• Cash equivalents (liquid assets such as accounts receivable, treasury bills, securities, certificates of deposit and, in certain cases, precious metals)
• Inventory

Liabilities: Liabilities are what the sole proprietor or the company needs to pay in order to ensure the smooth functioning of the business. Liabilities typically include the following:

• All forms of debt
• Rent
• Taxes
• Utilities
• Salaries and wages
• Dividends payable.

Owners Equity: Owner's equity is calculated by subtracting the owner's draws or withdrawals from the business from his/her investment in the business and then adding the net income (or subtracting the net loss) since the time of inception of the business.

Stockholders Equity: Stockholders equity is calculated by subtracting a company's total liabilities from its total assets. So, in essence, stockholders equity is the sum of money that would be payable to shareholders in the event of a liquidation of all of the assets of the company as well as the paying off of all its debts.

## Steps in an Accounting Equation

In any balance sheet, the total debits must be equal to the total credits. Therefore, an accounting equation mandates that any change to an asset account must be accompanied by an equal change to a related liability or equity account. The accounting equation can be calculated by following these steps in the balance sheet;

1. Calculating the total assets on the balance sheet for the period of consideration.
2. Creating a separate list of the sum of all liabilities on the balance sheet.
3. Calculating total owners equity or total shareholders equity.
4. Adding up the sum of liabilities and the total owners/shareholders equity, which will equal the sum of the assets.

## Importance of the Accounting Equation

The accounting equation is essential since it enables an assessment of the accuracy of recording business transactions carried on by the individual or the company in all relevant books and accounts. This makes it possible to accurately assess the financial position of any business via its balance sheet.