If your small business uses the double entry accounting system, you may have heard the term “accounting equation.” What does this mean, and why does it matter to your business? Here’s a closer look at the accounting equation.
The Accounting Equation: A Balancing Act
Sometimes called the basic accounting equation, the accounting equation is the foundation of double entry accounting, a system where every financial transaction is entered into two places in the business’s books—as a debit and as a credit. While very small or simple businesses may be able to get by with single entry accounting, double entry accounting builds in some important forms of error checking.
The accounting equation is this:
Assets = Liabilities + Owner’s (or Stockholders’) Equity
- Assets are everything your business owns. Examples of assets include tangible assets, such as cash, receivables, inventory, equipment, vehicles, and real estate, and intangible assets such as intellectual property (patents, copyrights, and trademarks).
- Liabilities are payments your company has to make. Examples of liabilities include loan payments, lease payments, payments on lines of credit or credit cards, and other payables. There are two types of liabilities: short-term or current liabilities are due within 12 months, and long-term liabilities are due to be paid off more than 12 months after the current date.
- Owner’s Equity or Stockholders’ Equity refers to how much of the business belongs to you (or, if your business issues stock, to the stockholders). It’s also expressed as assets minus liabilities, and is not to be confused with the value of the business.
At all times, both sides of the accounting equation should balance out. In other words, if your business’s assets total $200,000, the sum of its liabilities plus owner’s equity should also be $200,000. If not, something is wrong with the math or has been entered incorrectly.
Here are some examples of how you would use double entry bookkeeping and how it affects the accounting equation:
- If you borrow $25,000 from a bank, your assets increase by $25,000; however, your liabilities also increased by $25,000 (because you have to pay the loan back).
- If you finance invoices worth $1,300, your assets increase by $1,300 and your liabilities increase by $1,300.
- If you make a sale of $5,000, your assets increase by $5,000, and the owner’s equity increases by $5,000.
- If you purchase equipment for $8,000, your liabilities increase by $8,000, and the owner’s equity decreases by $8,000.
Each financial transaction that your business enters into must be recorded in two of the three categories: assets, liabilities, and owner’s equity. If you follow double entry accounting correctly, both sides of the accounting equation will be equivalent.
What Is the Accounting Equation Used for?
As you can see, the accounting equation is an important tool in double entry accounting. It helps ensure that debits and credits are recorded accurately. Beyond this, however, it helps to measure how profitable your business is. The accounting equation is the foundation of your company’s balance sheet, which expresses your business’s assets, liabilities, and owner’s or shareholder’s equity in detail.
If you’re looking for business financing, the accounting equation can be an important tool for investors or lenders used to assess your company’s financial situation. Does the company have much higher liabilities than assets? This could indicate that you’re not managing your money very well.