Definition: The accounting equation or balance sheet equation forms the building blocks for the entire double entry accounting system. It shows that every asset owned by the company is equal to the claims (liabilities and equity) against the asset. The accounting equation looks like this. Asset = Liabilities + Equity.
In its most basic form, the accounting equation shows what a company owns, what a company owes, and what stake the owners have in the business. The equation starts off with the company assets. These are the resources that the company has to use in the future like cash, accounts receivable, equipment, and land.
What Does Accounting Equation Mean?
Most of the time, the company doesn’t own its assets completely outright. There are claims to these assets. For instance, the company might have a loan on the company car, a mortgage on the building, or even owe money to its shareholders. That is why the second part of the accounting equation is made up of the claims on company assets. All of these claims on the company assets are separated into two categories: liabilities and equity.
Liabilities are claims on the company assets by other companies or people. In other words, it’s the amount of money owed to other people. A bank loan or mortgage is a good example. The bank has a claim to the business building or land that is mortgaged.
Equity on the other hand is the shareholders’ claims on the company assets. This is the amount of money shareholders have contributed to the company for an ownership stake. Equity also includes retained earnings. Equity is usually shown after liabilities in the accounting equation because liabilities must have to be repaid before owners’ claims. You might also notice that the accounting equation is in the same order as the balance sheet.
Once all of the claims by outside companies and claims by shareholders are added up, they will always equal the total company assets.