Accounting Equation, also called the basic accounting equation, forms the foundation for all accounting systems. In fact, the entire double entry accounting concept is based on the basic accounting equation. This simple equation illustrates two facts about a company: what it owns and what it owes.
The accounting equation equates a company’s assets to its liabilities and equity. This shows all company assets are acquired by either debt or equity financing. For example, when a company is started, its assets are first purchased with either cash the company received from loans or cash the company received from investors. Thus, all of the company’s assets stem from either creditors or investors i.e. liabilities and equity.
As you can see, assets equal the sum of liabilities and owner’s equity. This makes sense when you think about it because liabilities and equity are essentially just sources of funding for companies to purchase assets.
This equation holds true for all business activities and transactions. Assets will always equal liabilities and owner’s equity. If assets increase, either liabilities or owner’s equity must increase to balance out the equation. The opposite is true if liabilities or equity increase.
The financial position of a company is measured by the following items:
An asset is a resource that is owned or controlled by the company to be used for future benefits.
- Tangible Assets: Assets which have a physical existence and can be touched and felt are called Tangible Assets. Tangible assets can include both fixed and current assets.
Ex: Furniture,Machinery,Plant,Cash in hand,Buildings,
- Intangible Assets: An intangible asset is an asset that is not physical in nature. Ex: patents,trademarks,copyrights,Goodwill.
A liability, in its simplest terms, is an amount of money owed to another person or organization. Said a different way, liabilities are creditors’ claims on company assets because this is the amount of assets creditors would own if the company liquidated.
Ex: Accounts payable,Bank loan,Personal Loans,Etc,.
3. Owner’s Equity
Equity represents the portion of company assets that shareholders or partners own. In other words, the shareholders or partners own the remainder of assets once all of the liabilities are paid off.
Owners can increase their ownership share by contributing money to the company or decrease equity by withdrawing company funds. Likewise, revenues increase equity while expenses decrease equity.
Ex: Owner’s Capital,Revenues,Owner’s Withdrawals,Expenses.