Thus, the accounting equation is always matched in all of the above transactions, i.e., increase/ decrease takes place with the same amount. The last component of the accounting equation is owner’s equity. Initial start-up cost of a company that comes from the owner’s own pocket – that’s a good example of owner’s equity. Understand what the accounting equation is, learn the elements of the basic accounting equation, and see examples. One is to consider equity as any assets left over after deducting all liabilities. In fact, the equation for determining how much equity a company has is subtracting the company’s liabilities from its assets. Liabilities are amounts of money that the company owes to others.

Why Is the Accounting Equation Important?

The accounting equation captures the relationship between the three components of a balance sheet: assets, liabilities, and equity. All else being equal, a company’s equity will increase when its assets increase, and vice-versa. Adding liabilities will decrease equity while reducing liabilities—such as by paying off debt—will increase equity. These basic concepts are essential to modern accounting methods.

We are not permitted to carry out regulated business activities. Barbara is currently a financial writer working with successful B2B businesses, including SaaS companies. She is a former CFO for fast-growing tech companies and has Deloitte audit experience. Barbara has an MBA degree from The University of Texas and an active CPA license. When she’s not writing, Barbara likes to research public companies and play social games including Texas hold ‘em poker, bridge, and Mah Jongg. The initial contribution to the business is recorded in the same way but with the new amount, as shown in Figure 4. Distributions to ownersdecreasethe value of the organization.

Introduction to Accounting Equation

Shanti purchases the laptop with a credit card, and the clerk finalizes the sale. Figure 5 shows the impact of the sale on the accounting equation.

  • The accounting equation emphasizes a basic idea in business; that is, businesses need assets in order to operate.
  • The new corporation purchased new asset for $5,500 and paid cash.
  • Locate the company’s total assets on the balance sheet for the period.
  • The ownership percentage depends on the number of shares they hold against the company’s total shares.
  • The value of liabilities also keeps on changing from time to time.
  • Liabilities are amounts of money that the company owes to others.

Woofer one of its Current Assets accounts, Cash, for the same amount, $1,180. For an explanation of double-entry accounting, see double-entry Accounting Systems.

Define Accounting Equation

These are what the company holds onto at the end of a period to reinvest in the business, after any distributions to ownership occur. Stated more technically, retained earnings are a company’s cumulative earnings since the creation of the company minus any dividends that it has declared or paid since its creation. One tricky point to remember is that retained earnings are not classified as assets.

Any personal investment will your owner’s equity. In this case, the 2 accounts lie on the opposite sides of the accounting equation. Receivables arise when a company provides a service or sells a product to someone on credit. We will increase the expense account Utility Expense and decrease the asset Cash. We record this as an increase to the asset account Accounts Receivable and an increase to service revenue. The new corporation purchased new asset for $8,500 and paid cash. We want to increase the asset Equipment and decrease the asset Cash since we paid cash.