For example, Accumulated Depreciation is a contra asset account, because its credit balance is contra to the debit balance for an asset account. This is an owner’s equity account and as such you would expect a credit balance. Other examples include (1) the allowance for doubtful accounts, (2) discount on bonds payable, (3) sales returns and allowances, and (4) sales discounts. For example net sales is gross sales minus the sales returns, the sales allowances, and the sales discounts.

The accounting equation is not just theoretical; it has real-world applications in managing a company’s state unemployment insurance sui rates finances. A corporation’s own stock that has been repurchased from stockholders. Also a stockholders’ equity account that usually reports the cost of the stock that has been repurchased. Advertising Expense is the income statement account which reports the dollar amount of ads run during the period shown in the income statement.

The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet. The representation essentially equates all uses of capital or assets to all sources of capital where debt capital leads to liabilities and equity capital leads to shareholders’ equity. The accounting equation is a fundamental concept that states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity. This straightforward relationship between assets, liabilities, and equity is the foundation of the double-entry accounting system.

• The totals tell us that the company has assets of $9,900 and that the only claim against those assets is the stockholders’ claim.
• CFI is on a mission to enable anyone to be a great financial analyst and have a great career path.
• After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career.
• This is because creditors – parties that lend money such as banks – have the first claim to a company’s assets.
• Creditors and owners can both stake a claim on the assets of a company.

From evaluating financial performance to ensuring compliance with accounting standards, the equation plays a central role in business operations. As technology advances, its application becomes even more seamless, enabling businesses to focus on strategy and growth while maintaining financial integrity. The accounting equation isn’t just a formula—it’s the foundation of trust and accountability in the world of finance. For instance, when a sale is made, the software automatically updates the accounts for cash or receivables, revenue, and inventory, maintaining the equation’s balance without manual intervention.

Transaction 1:  Nupur started a business with cash $20,000.

This is a contra owner’s equity account, because it has a debit balance if draws were made. Even though it is a balance sheet account, it is a temporary account. At the end of each year the account’s debit balance is closed to J.

The side of the accounting equation representing assets must always be balanced with equity and liabilities. Any changes—such as an increase in liabilities or new equity investments—must be reflected accordingly. Tracking assets helps businesses understand their financial strength. For example, purchasing a delivery truck increases a company’s total assets, impacting both its financial statements and what is cash flow operations.

The accounting equation is a core concept of modern accounting that states that a company’s assets are the sum of its liabilities and its shareholder equity. Understanding how equity is determined brings clarity to a company’s overall worth. By grasping key accounting principles, businesses can prevent costly mistakes and use financial insights for smarter decision-making. These concepts aren’t just theoretical—they’re essential for accurate reporting and long-term success. Many assume that financial formulas and tracking methods only matter for big corporations. However, businesses of all sizes—whether using manual records or accounting software—need a reliable way to monitor assets, liabilities, and equity.

Terms Similar to Accounting Equation

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For example, imagine that a business’s Total Assets increased by $500. This change must be offset by a $500 increase in Total Liabilities or Total Equity. If we rearrange the Accounting Equation, Equity is equal to Assets minus Liabilities.

Profits retained in the business will increase capital and losses will decrease capital. The accounting equation will always balance because the dual aspect of accounting for income and expenses will result in equal increases or decreases to assets or liabilities. Accounting equation describes that the total value of assets of a business entity is always equal to its liabilities plus owner’s equity. This equation is the foundation of modern double entry system of accounting being used by small proprietors to large multinational corporations.

Challenges in Applying the Accounting Equation

Instead, the amount is initially recorded in the expense account Advertising Expense and in the asset account Cash. You can interpret the amounts in the accounting equation to mean that ASC has assets of $10,000 and the source of those assets was the owner, J. Alternatively, you can view the accounting equation to mean that ASC has assets of $10,000 and there are no claims by creditors (liabilities) against the assets. As a result, the owner has a residual claim for the remainder of $10,000.

Purchasing a Machine with Cash and Credit

Borrowing money and making purchases on credit are common practices for companies of every size. In order to carry out its operations, such as production and sales, the company uses its assets. (Some corporations have preferred stock in addition to their common stock.) Shares of common stock provide evidence of ownership in a corporation. Holders of common stock elect the corporation’s directors and share in the distribution of profits of the company via dividends. If the corporation were to liquidate, the secured lenders would be paid first, followed by unsecured lenders, preferred stockholders (if any), and lastly the common stockholders. A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold.

CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path. It represents the total profits that have been saved and put aside or “retained” for future use. The major and often largest value assets of most companies are their machinery, buildings, and property.

The equation closing and dissolving a charity forms the structure of the balance sheet, categorizing assets, liabilities, and equity. It also influences the income statement and cash flow statement by tracking changes in revenue, expenses, and cash movement. The accounting equation shows how every business transaction impacts financial records. For example, taking out a loan increases both total assets (cash received) and liabilities (loan obligation) by the same amount.

• This principle ensures that the Accounting Equation stays balanced.
• One account will have the amount entered on the left-side (a debit entry), while another account will have the amount entered on the right-side (a credit entry).
• This equation helps companies evaluate their financial health, perform accurate bookkeeping, measure profitability, etc.
• The accounting equation shows the amount of resources available to a business on the left side (Assets) and those who have a claim on those resources on the right side (Liabilities + Equity).
• The accounting term that means an entry will be made on the left side of an account.

Although revenues cause owner’s equity to increase, the revenue transaction is not recorded directly into the owner’s capital account. At some point, the amount in the revenue accounts will be transferred to the owner’s capital account. The accounting equation remains in balance since ASC’s assets have been reduced by $100 and so has the owner’s equity. Like any mathematical equation, the accounting equation can be rearranged and expressed in terms of liabilities or owner’s equity instead of assets. The accounting equation ensures that the balance sheet remains balanced. Each entry made on the debit side has a corresponding entry or coverage on the credit side.

So, as long as you account for everything correctly, the accounting equation will always balance no matter how many transactions are involved. For example, an increase in an asset account can be matched by an equal increase to a related liability or shareholder’s equity account such that the accounting equation stays in balance. Alternatively, an increase in an asset account can be matched by an equal decrease in another asset account. It is important to keep the accounting equation in mind when performing journal entries.

Other names used for this equation are balance sheet equation and fundamental or basic accounting equation. This fundamental principle in accounting says that a company’s assets must always be equal to the total of its liabilities and owner’s equity, maintaining accurate and balanced financial records. Learning the accounting equation is a crucial skill for anyone involved in creating and understanding financial statements. Due to this, the accounting equation is also called the balance sheet equation sometimes. Our Explanation of Accounting Equation (or bookkeeping equation) illustrates how the double-entry system keeps the accounting equation in balance. You will see how the revenues and expenses on the income statement are connected to the stockholders’ equity on the balance sheet.

A balanced sheet also shows the company’s liabilities and shareholders’ equity. This ensures the equation is followed, a key part of the accounting cycle, and provides a clear financial snapshot of the business. Another widespread myth is that financial figures remain unchanged unless major transactions occur. In reality, every payment, sale, or expense affects a company’s financial position. These ongoing updates shape the balance sheet and provide a real-time view of overall stability. Every financial transaction affects at least two components of the equation.