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Accounting equation - What is the accounting equation?

The accounting equation is the formula used to capture the effect of the relationship of financial activities within a business

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The equation is a simplified breakdown of the values entered in the balance sheet. It illustrates the relationship between a company's assets, liabilities (amounts owed to others), and shareholder or owner equity (the value of an asset minus the liabilities associated with that particular asset).

Balance in accounting

The accounting equation shows the balance of a company’s resources (those displayed on the balance sheet as assets). The company’s assets are shown on the left side of the equation, and the liabilities and equity (the total claims to those assets) are shown on the right side. The equation illustrates that all of a company’s resources (assets) are provided by their creditors or their owners ( through liabilities and equity).

The accounting equation also shows that every economic event that affects the balance sheet will have a dual effect: a company’s resources will always have equal claims.

The equation and what it means

The equation is typically written as:

Assets = Liabilities + Owner Equity

It can also be structured as:

Liabilities = Assets - Owner Equity

Owner Equity = Assets - Liabilities

The accounting equation is a simple way to view the relationship of financial activities across a business. The balance sheet essentially takes care of filling in each of the values in the equation, so the equation is not meant for actual use but is instead a simplified representation of how the financial side of a business functions.

The accounting equation in action

An example of how the three values relate: If a business wishes to purchase a new asset, such as computer equipment that costs £300, the purchase can be made using cash (an asset), with owner equity (earnings or funds) or with a liability (such as borrowed money). If a liability is used for the purchase, the £300 can then be paid off using assets or with the use of a new liability, such as a bank loan.