Accounting Equation in Layman’s Terms
The accounting equation is calculated as follows: assets=liabilities + capital, where capital equals either stockholder equity in a corporation or owner equity in a private firm. This equation is necessary for keeping a balance sheet in the double-entry bookkeeping system, in which debits and credits must be equal.
This formula for balancing accounts dates back to before the Italian Renaissance, when accountants used a similar equation to keep track of accounts. Though this is the earliest documented evidence of accounting equations and bookkeeping balances; many historians believe that other Arab and Muslim cultures employed these practices first, later sharing it with Italian traders with whom they conducted business.
Today, the assets determined by this accounting equation formula are made up of a business’s various holdings. For a business that has just opened, these assets typically include the money invested by an owner or creditor. Businesses that have been up and running for a longer period of time will count any additional gains, contributions, and revenue as assets. These might include cash, accounts receivable, insurance, land, equipment, and inventory. According to the accounting equation, these must be equal to the liabilities and equity.
Capital, otherwise known as equity, can belong to a company owner or shareholder (often, the owner is also an investor in a company). This capital is essentially the leftover profit after liabilities have been subtracted from assets, and is otherwise known as the company’s net income or retained earnings. Capital can also refer to the money owed to a company owner or shareholder; in the case of an outside investment for a company start-up, equity and liability would be equal.
Liabilities amount to a company’s debts and debits-money a business owes to others, from creditors to employees. For example, these might include cash purchases for goods or services (otherwise known as accounts payable), salaries, dividends, losses, or loan interest payments. These are either categorized as long-term or short-term liabilities; in the former case, they must be paid back in less than one year. In many cases, such as that of hiring employees or purchasing equipment, liabilities can be seen as the source or a company’s assets
Accounting equations remain stable at all times. In other words, while the number or monetary value of business transactions might change frequently, the equation itself will always remain the same, and will always remain balanced. This is because every transaction a company makes from one account affects the other two accounts; for instance, taking out a loan (shareholder equity) increases assets and liability. This process is also called “double entry accounting” or “double entry bookkeeping.”
All of these accounting equation figures are recorded by a bookkeeper in an accounting ledger known as a balance sheet. These ledgers are divided into specific sections according to asset, liability, and equity, with subdivisions for the different variations of those larger categories (e.g. cash purchases or investments). These ledgers must remain balanced on either side at all times; an imbalance indicates an oversight or error in calculation.
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