The accounting equation is the base of “Double Entry Book Keeping System”. The equation indicates the relation between the means owned and resources owned by the business. The definition of accounting equation with the principle of “equality” duly finds its effect on the balance sheet with the “Asset Side” being a sum total of “Liabilities and Shareholder’s Equity. This is a clear indication of “two-fold effect” as in the double entry system stating that “For every debit, there is an equal amount of credit”. The accounting equation is the primary concept for a preparation of all financial statements based on journal entries.

The accounting equation formula is expressed in the algebraic form as:

Where,

A = Assets of the Entity (What the business owns)

L = Liabilities of the entity (Outsider’s Claims i.e. what the business owes to outsiders)

C or S = Capital of the Entity (Owner’s/Shareholder’s Claims i.e. Capital + Net Profit/Loss – Dividends)

The accounting equation indicates that total assets of the business are being financed from either borrowed money (liabilities) or from owner’s funds/shareholder’s money (Capital + Retained Earnings) or by reduction of existing assets.

This basic accounting equation can also be expressed as:

    The accounting equation shows that “Asset” can be purchased from “assets” or from “Liabilities” i.e. outside borrowing or from “Owner’s Equity / Shareholder’s Equity” i.e. For purchasing a machine of $3000, one can use cash (Asset) or buy it from borrowing the money from someone (Liability) or from owner’s funds (Capital/Shareholder’s Equity).

Similarly, to pay liability of $2000, one can use some other debt (Liability) or can use some Asset (Cash or Stock) or pay it off from retained profits (Owner’s Equity).