Accounting equation is the primary principle of accounting and the basic element of the balance sheet. It states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity.
The accounting equation ensures that the balance sheet remains balanced. This means any change in the assets of a company should have equal impact/change in related liability and stockholder’s equity.
This simple equation between assets, liabilities, and shareholder’s equity is considered to be the foundation of the double-entry accounting system.
An asset is anything with economic value that a company owns and controls that can be used to benefit the business now or in the future such as fixed assets such as machinery, stocks, bonds and buildings.
Liabilities is anything that a company owes to the outsiders which includes every debt it has incurred, accounts payable, mortgages and accrued expenses.
Shareholders’ equity is the owner’s capital or the value of the company. In other words, it is the amount that would be returned to the shareholders if the company liquidated all of its assets and paid off all of its debts on the balance sheet date.
The Formula for the Accounting Equation
Assets = Liabilities + Shareholder’s Equity
Example of Accounting Equation:
For the year, a leading company XYZ limited incorporated the following points on its balance sheet:
Total assets: Rs. 200 crore
Total liabilities: Rs. 80 crore
Total shareholders’ equity: Rs. 120 crore
If we evaluate the accounting equation (Liabilities + Equity), we arrive at (Rs.80 Crore + Rs. 120 Crore) = Rs. 200 Crore, which equals to the assets reported by the XYZ Limited.
Any changes in the assets of XYZ limited will have equal impact on the liability and stockholder’s equity account.
