|The accounting equation is the foundation for double entry bookkeeping and producing the financial reports.|
The accounting equation balances the assets on one side of the equation, with interests or claims to those assets on the other.
The accounting balance sheet, therefore, always maintains equality from the basic accounting equation:
The Accounting Equation
|Assets = Liabilities + Owner’s Equity|
The accounting equation can be restated as:
|Assets – Liabilities = Owner’s Equity|
|Assets – Owners Equity = Liabilities|
The Accounting Equation and Double Entry Bookkeeping
The accounting equation applies to every transaction in financial accounting because it is the foundation of double entry bookkeeping. Double entry bookkeeping ensures that every transaction keeps the accounting equation in balance.
For example, if Sunny deposits $100,000 into a business account setup for Sunny Sunglasses Shop to start his business, the balance sheet would show an asset for $100,000 in the form of cash, and $100,000 for owner’s equity:
If Sunny acquired a building for $100,000 using his own cash as an initial investment in the business, instead of depositing cash, the balance sheet would show:
The asset, in this case the building, equals the total owner’s investment in the business, or $100,000.
Both the deposit of cash into a business account to start his business, and the purchase of a building by the owner(s) investing in the business, have the same effect on the accounting equation:
|Assets (Cash or Building)||= Liabilities||+ Owner’s Equity|
If Sunny did not have cash to purchase a building, or simply wanted to conserve his cash for other business uses, he could take out a mortgage to fund the building. Sunny puts down $20,000 as a down payment, and takes out a mortgage for $80,000.
The balance sheet and the accounting equation would now include a liability for the mortgage as follows:
The effect on the basic accounting equation now appears as:
|Assets||= Liabilities||+ Owner’s Equity|
|Assets||– Liabilities||= Owner’s Equity|
Owners equity represents the ownership interest of the business when liabilities are subtracted from assets. Owners equity is also called book value, or net book value, and is the first sign of a healthy or weak balance sheet. For publicly traded companies, book value is also called stockholders equity and is often expressed on a per-share basis (stockholders equity/shares outstanding = book value per share).
Negative book value results when liabilities are greater than assets. Increasing book value is one of the key indicators of business success, since book value directly impacts the intrinsic value of the company, and if publicly traded, the share price.
The online accounting examples throughout this website show how accounting transactions affect the accounting equation.