Accounting Equation Explained Definition & Examples

Most early and mid-stage businesses can’t justify a full-time CFO, yet they still require sophisticated financial leadership to optimize their accounting equation components. This is precisely where fractional, interim, and virtual CFO services deliver exceptional value. This structure isn’t coincidental—it’s deliberately designed to reinforce the accounting equation with every statement produced. The balance sheet literally “balances” because it must satisfy the accounting equation. Financial ratios built on accounting equation components—like debt-to-equity ratio, Quick Ratio, or return on assets—drive strategic decision-making.

Advance Your Accounting and Bookkeeping Career

These arrangements provide seasoned financial executives who have managed accounting systems across multiple companies and industries. This diverse experience brings pattern recognition that helps identify optimization opportunities others might miss. In reality, though, they would be more responsible for the operational side of transaction recording and statement preparation, rather than the strategic implications of the equation’s components. Who in your business handles financial statement preparation and integrity? In many growing companies, this responsibility falls into a confusing gap.

To prepare the balance sheet and other financial statements, you have to first choose an accounting system. The three main systems used in business are manual, cloud-based accounting software, and ERP software. Now, these changes in the accounting equation get recorded into the business’ financial books through double-entry bookkeeping. For companies seeking to optimize their accounting systems, experienced financial leadership makes all the difference. Whether your business is establishing basic bookkeeping processes or refining sophisticated financial reporting, the accounting equation remains your fundamental reference point. By maintaining this balance, you create the financial clarity needed to drive informed strategic choices.

The accounting equation maintains its balance because the $5,000 expense reduces both cash (asset) and retained earnings (equity) by equal amounts. This elegant system ensures every transaction can be traced through the accounts, creating an audit trail that validates financial integrity. With the accounting equation expanded, financial analysts and accountants can better understand how a company structures its equity. Additionally, analysts can see how revenue and expenses change over time, and the effect of those changes on a business’s assets and liabilities. If the left side of the accounting equation (total assets) increases or decreases, the right side (liabilities and equity) also changes in the same direction to balance the equation. 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.

Sole Proprietorship Transaction #8.

As you can see, ASC’s assets increase by $10,000 and so does ASC’s owner’s equity. The balance sheet always balances out but the accounting equation can’t tell investors how well a company is performing. It will result in an increase in the company’s inventory which is an asset while reducing cash capital which is another asset if a business buys raw materials and pays in cash. Two or more accounts are affected by every transaction carried out by a company so the accounting system is referred to as double-entry accounting.

That part accounting equation explained of the accounting system which contains the balance sheet and income statement accounts used for recording transactions. The accounting equation tells us that ASI has assets of $10,000 and the source of those assets were the stockholders. Alternatively, the accounting equation tells us that the corporation has assets of $10,000 and the only claim to the assets is from the stockholders (owners).

There was no shareholder’s equity involved in this, so it is 0 in the balance sheet for purchasing a truck.
Since the amount of the increase is the same as the amount of the decrease, the accounting equation remains in balance.
The three main systems used in business are manual, cloud-based accounting software, and ERP software.
Assets are purchased to increase the earning capacity of the business.

Accounting Equation and the Balance Sheet

Barbara has an MBA from The University of Texas and an active CPA license. When she’s not writing, Barbara likes to research public companies and play Pickleball, Texas Hold ‘em poker, bridge, and Mah Jongg. This also includes debt that might have been taken by the company in order to arrange for finances. Accounting can be considered one of the most important ancillary functions within the company. This is primarily because of the reason that it gives a direct insight into the performance of the company, which can eventually be used as a very important tool for decision-making. If you want to know more about accounting errors and how to spot them, we recommend reading Common Accounting Errors – A Practical Guide With Examples.

A strategic approach to your financial equation could make all the difference. Generally Accepted Accounting Principles (GAAP) are built on the accounting equation’s foundations, making it essential for regulatory compliance. It’s essential as a business owner, founder, or even a startup CEO to understand how this foundational concept impacts every financial decision your company makes. Every liability represents a claim against assets—essentially, how much of your business belongs to others.

For better recognition, some examples of assets are the company’s building, plant, machinery, property, inventory, etc.
Service Revenues is an operating revenue account and will appear at the beginning of the company’s income statement.
When inventory items are acquired or produced at varying costs, the company will need to make an assumption on how to flow the changing costs.
If the revenues come from a secondary activity, they are considered to be nonoperating revenues.
So, in other words, it is the universal equation in accounting, which forms the most basic principle of accounting.

In double-entry accounting or bookkeeping, total debits on the left side must equal total credits on the right side. As a result of how each recorded accounting transaction affects the general ledger with balanced debits and credits, the financial statements are in balance. The accounting equation states that the total assets of the individual or the business equals the sum of the liabilities and equity. In the case of an individual, the total assets equal the sum of liabilities and owners equity, whereas in the case of a company, the sum of assets equals the sum of liabilities and stockholders equity. Thus from the above details we can understand how to do accounting equation.

Accounting Equation: a Simple Explanation

For example, you can talk about a time you balanced the books for a friend or family member’s small business. We will now consider an example with various transactions within a business to see how each has a dual aspect and to demonstrate the cumulative effect on the accounting equation. The accountants should ensure that the concept of accounting equation and its rules are properly followed and the transactions are daily and accurately recorded. Some examples of liabilities are taxes, accounts payable, deferred revenue, and accrued expenses. This can be a serious asset to have when a company is experiencing a cash-flow problem. That is why in a balance sheet under assets, Cash is the first one declared.

Liabilities can simply be defined as the amount that the company owes to its suppliers, in exchange of goods (or services) that have already been provided for but not yet paid for. Liabilities can be regarded as obligations that need to be honored by the company in order to settle the respective accounts. A single interface gives you access to all remarkable features, including the ability to add products, services, and inventory. Deskera Books is an online accounting software that enables you to generate e-Invoices for Compliance. It lets you easily create e-invoices by clicking on the Generate e-Invoice button. With Deskera you can automate other parts of the accounting cycle as well, such as managing inventory, sending invoices, handling payroll, and so much more.

Creditors include people or entities the business owes money to, such as employees, government agencies, banks, and more. Typically, it would be the responsibility of the Controller or bookkeeper to maintain the day-to-day balance of the accounting equation. Perhaps the most overlooked component in basic accounting, drawings (or withdrawals) represent the value that owners take out of the business. Many small businesses fail because owners extract too much capital without realizing how it impacts overall financial health. The double-entry system operates through debits and credits, which must always balance.

Retained Earnings is Beginning Retained Earnings + Revenue – Expenses – Dividends – Stock Repurchases. Accounting software is a double-entry accounting system that automatically generates the trial balance. The trial balance includes columns with total debit and total credit transactions at the bottom of the report.

The accounting equation tracks economic resources and obligations, not just cash. Many transactions affect the equation without involving cash movement. The accounting equation can still feel a bit abstract until put into practice with real-world business transactions. Remember, the accounting equation measures economic resources, economic obligations, and economic interests, which are the building blocks of all business transactions. The accounting equation, while generally simple within a broad view, can be broken down into very specific financial business instruments. Additionally, you can use your cover letter to detail other experiences you have with the accounting equation.

On the liabilities side of a balance sheet, short-term and long-term debt are listed first of all. These are the payments that are to be paid to the company by its customer. These are also considered an asset, but accounts receivables are not as liquidate as Cash.

Accounting Equation Explained – Definition & Examples

Ted is an entrepreneur who wants to start a company selling speakers for car stereo systems. After saving up money for a year, Ted decides it is time to officially start his business. He forms Speakers, Inc. and contributes $100,000 to the company in exchange for all of its newly issued shares.