Although the accounting equation is simple - Assets – Liability = Equity, many people don’t know how it applies in real life examples and what equity event means.
Equity is pretty much the base net worth of a business (or person). So let’s say one day, someone calculates how much you own (house, car etc…) less how much you owe (to the bank, to friends and family etc…) what’s left is how much you’re ‘worth’ in financial terms.
The accounting equation is also known as the balance sheet equation and shows how what you own (that's your assets), and what you owe (being your liabilities) affect the business. Every action in the business affects this equation in some way, making the net worth of the business increase or decrease.
If you want to understand the accounting equation, just watch this super quick video (less than 3 minutes!)
Let’s see the accounting equation in action by going through some real life examples:
Example 1 – Sales & Expenses affect Assets
Say, your business earns $400 sales and only $200 in expenses for the year and all of this has been paid. The sales will go in the cash account to increase it, and the expense will go into reducing cash. When you do the calculation, that means you should have $200 left in cash ($400 cash in from sales less $200 cash out from expenses). The $200 in profit is recognized in retained earnings (equity).
This means that for the equation:
Assets – Liability = Equity
Assets are up by $200 and Equity is up by $200.
Example 2 – Borrowing to buy a car
Let’s say you buy a car, for $10,000 and borrow $10,000.
Well, you’d record cash that your borrowing has gone up (that’s money you owe) you borrowed $10,000, your cash up for $10,000 and then cash goes down now for $10,000 because this cash is used to buy a car for $10,000.
So… what you end up with is $10,000 for a car and $10,000 that you owe.
At the end of it, cash zeros out, and you've got a car for $10,000 and a liability, your borrowing for $10,000.
Again, the accounting equation of assets – liabilities = equity balances out.
Example 1 & 2 Together
When you put example 1 & 2 together, you get an accounting equation that looks like this:
Assets ($10,200) – Liabilities ($10,000) = Equity ($200)
This balances because the left side = $200 and the right side = $200.
The accounting equation still makes adds up properly math-wise.
What happens if my equation doesn’t balance?
The equation should balance if you’re entered in your data correctly.
If it doesn’t balance, you’ve got an error somewhere – this could be in your data entry so a review of your data is important.
How do I find what liabilities or assets should be from the accounting equation
Because the accounting equation is an equation. You can rearrange it to get what you need.
Assets – Liabilities = Equity
To get assets only:
Assets = Equity + Liabilities
To get liabilities only:
Liabilities = Assets - Equity
Therefore, if you want to calculate how much a business owes, you can just use Assets - Equity equals your Liabilities and then your Assets would be your Equity plus your Liabilities figure.
The accounting equation is a useful way to see a business’ basic net worth – this is important in understanding how much it owns and debts at a point time. It’s useful information to business owners, investors and banks for things like loan applications.