The Accounting Equation
The fundamental principle that keeps all business transactions in balance
Understanding the Foundation
Every business transaction follows one simple rule: what the company owns must equal what it owes plus what belongs to the owners. This is the accounting equation, and it's the foundation of all financial record-keeping.
What you own = What you owe + What you're worth
Assets
Resources owned by the business: cash, equipment, inventory, buildings
Liabilities
Debts owed to others: loans, accounts payable, mortgages
Equity
Owner's claim on the business: invested capital, retained earnings
💡 Professor's Tip
"Think of the accounting equation like a scale. The left side (Assets) must always equal the right side (Liabilities + Equity). When one side changes, the other side must change too to keep everything balanced!"
See It In Action
Starting a Business
Sarah starts a consulting business with $10,000 cash
Assets
$10,000 (Cash)
Liabilities
$0
Equity
$10,000 (Owner's Investment)
Sarah's personal investment becomes the company's equity, balancing the equation.
Buying Equipment
Sarah buys a laptop for $2,000 using company cash
Assets
$10,000 (Cash: $8,000 + Equipment: $2,000)
Liabilities
$0
Equity
$10,000
Assets shift from cash to equipment, but total assets remain the same.
Taking a Loan
Sarah takes a $5,000 loan to buy office furniture
Assets
$15,000 (Cash: $8,000 + Equipment: $2,000 + Furniture: $5,000)
Liabilities
$5,000 (Bank Loan)
Equity
$10,000
Both assets and liabilities increase by $5,000, keeping the equation balanced.
Ready for the Next Step?
Now that you understand the accounting equation, let's explore how it's used to create the three essential financial statements.
Next: Understand Financial Statements