The Accounting Equation
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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 elements of a financial statement, i.e., 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)
This concept is a part of the double-entry accounting system. 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.
Let's take another example to understand it. Let's say you start a business with $10,000 cash. For the business, it's the owner's equity of $10,000. At the same time, the business now has cash of $10,000 which is an asset. As you can see, both sides of the accounting equation are balanced. Now let's say you use $2,000 to purchase furniture for the business. Now you have $8000 cash and furniture worth $2000. The equation is still balanced (assets worth $10,000 - $8,000 cash and $2,000 of furniture). This way as you make more transactions in the business, the accounting equation always stays balanced.