Accounting Equation Definition, Basic Example How to Interpret?

This makes it possible to accurately assess the accounting equation position of any business via its balance sheet. This straightforward relationship between assets, liabilities, and equity is considered to be the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the debit side has a corresponding entry on the credit side. The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity.

Current assets include cash and cash equivalents, accounts receivable, inventory, and prepaid assets. Current liabilities are short-term financial obligations payable in cash within a year. Current liabilities include accounts payable, accrued expenses, and the short-term portion of debt. The accounting equation uses total assets, total liabilities, and total equity in the calculation. This formula differs from working capital, based on current assets and current liabilities.

What is the Expanded Accounting Equation?

Total assets are total liabilities, and shareholder’s equity is added together. The main use of this equation is for the accurate recording of the balance sheet. The double-entry practice ensures such accuracy by maintaining balance in each transaction. The accounting equation shows on a company’s balance that a company’s total assets are equal to the sum of the company’s liabilities and shareholders’ equity.

On a sheet of paper, use three columns to create your own accounting equation for your personal assets, liabilities, and expenses. In the third column, using the accounting equation, calculate the net amount of the asset . The laptop still costs $1,000, but the business has only $100 in cash assets.

What Is the Double-Entry Accounting System?

This straightforward equation on a company balance sheet is the foundation of thedouble-entryaccounting system and the basics of accounting. Double entry accounting is the term used to simply summarize that each debit has an equal credit , that keeps the books in balance. The accounting equation is the reason your balance sheet remains balanced.

• It’s important to note that here, debit and credit are not defined by their everyday usage.
• Now consider how to account for a situation in which Shanti does not have a significant amount of cash to contribute to the business.
• She can afford to contribute only $100 and deposits the money into the business’s bank account.
• The beautiful thing about accounting and the three-statement models it helps inform is that they create a closed system.

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Shareholders’ Equity SectionThe internal sources of capital that helped fund its assets, such as capital invested by the founders and issuances of equity financing.