Accounting equation

Definition

The accounting equation is the fundamental principle that states Assets = Liabilities + Equity. This equation forms the basis of double-entry bookkeeping and ensures that a company's financial statements are balanced.

5 Must Know Facts For Your Next Test

1. The accounting equation must always be in balance, meaning total assets should equal the sum of liabilities and equity.
2. It is used to prepare the balance sheet, one of the key financial statements.
3. Changes in either assets, liabilities, or equity will affect the overall balance but must still conform to the equation.
4. Equity represents the owner's residual interest after deducting liabilities from assets.
5. Understanding this equation is crucial for analyzing a company’s financial health.

Review Questions

• What components make up the accounting equation?
• How does purchasing equipment with cash affect the accounting equation?
• Why is it important for the accounting equation to remain balanced?

Related terms

Assets:

Resources owned by a company that have economic value.

Liabilities:

Debts and obligations that a company owes to external parties.

Equity:

The residual interest in the assets of an entity after deducting liabilities.