The accounting equation states that assets = liabilities + owner’s equity. Or to put it another way, a company’s economic resources must equal the value of the financial claims against those resources.
The accounting equation is a central feature of the double-entry system. We can think of the accounting equation like a scale whose two sides must always be in balance.
Every accounting transaction must be made so that the accounting equation holds. Consider the following transactions.
Transaction 1: Purchase $5,000 of inventory from a vendor who offers 30 days to payment
Transaction 2: Receive a $20,000 payment from a customer for an outstanding accounts receivable
Transaction 3: Purchase a work truck for $50,000. Pay $5,000 cash and borrow $45,000 from a bank
In the first transaction, assets (inventory) increase by $5,000 and liabilities (accounts payable) increase by $5,000. Both sides of the accounting equation increase by $5,000.
In the second transaction, one asset (cash) increases by $20,000 and another asset (accounts receivable) decreases by $20,000. Thus, total assets remained unchanged.
In the third transaction, one asset account (vehicles) increases by $50,000 and one asset account (cash) decreases by $5,000, while a liability account (notes payable) increases by $45,000. Thus, both sides of the accounting equation increase by $5,000.
The above examples illustrate a crucial point: for all appropriately recorded transactions, the accounting equation holds.