Businesses exchange items of equal value, real or perceived. Imagine that an exchange is like balancing a scale: the left side goes down (a service is given) and the right side reacts (cash is received) to maintain the balance of the scale.
Accounting uses a technique to show how a transaction changes the business’s resources while maintaining a balance, or showing the equal value of the exchange. This is called the accounting equation.
The accounting equation is a simple tool that helps us understand how various transactions affect the asset, liability, and owner’s equity accounts, and how these accounts are related to each other.
The accounting equation is presented as Assets = Liabilities + Owner’s Equity
Note that in case of a corporation, instead of owner’s equity we have shareholder’s equity as many shareholders invest money and have equity stake in the corporation.
This equation will always be balanced. So, if the business has assets worth $80,000, and owner’s equity of $20,000, then we can say that the liabilities are equal to $60,000.
$80,000 (Assets) = $60,000 (Liabilities) + $20,000 (Equity)
Every transaction will affect at least two of these accounts. If a transaction causes one side of the equation (assets) to increase, then the other side of the equation (liabilities or owner’s equity) must also increase to keep the equation in balance. It’s also possible that an increase in one asset causes another asset to decrease. In any case the accounting equation will always balance.