# The Basic Accounting Equation Formula & Explanation

An accounting transaction is a business activity or event that causes a measurable change in the accounting equation. Merely placing an order for goods is not a recordable transaction because no exchange has taken place. In the coming sections, you will learn more about the different kinds of financial statements accountants generate for businesses. If a business buys raw materials and accounting equation pays in cash, it will result in an increase in the company’s inventory (an asset) while reducing cash capital (another asset). Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting. The accounting equation is also called the basic accounting equation or the balance sheet equation.

Put another way, it is the amount that would remain if the company liquidated all of its assets and paid off all of its debts. The remainder is the shareholders’ equity, which would be returned to them. In other words, the total amount of all assets will always equal the sum of liabilities and shareholders’ equity. The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left side value of the equation will always match the right side value. Journal entries often use the language of debits (DR) and credits (CR). A debit refers to an increase in an asset or a decrease in a liability or shareholders’ equity.

## Calculate the accounting equation of Laura’s business at the end of the first month.

Thus, all of the company’s assets stem from either creditors or investors i.e. liabilities and equity. Shareholder Equity is equal to a business’s total assets minus its total liabilities. It can be found on a balance sheet and is one of the most important metrics for analysts to assess the financial health of a company.

Ted decides it makes the most financial sense for Speakers, Inc. to buy a building. Since Speakers, Inc. doesn’t have \$500,000 in cash to pay for a building, it must take out a loan. Speakers, Inc. purchases a \$500,000 building by paying \$100,000 in cash and taking out a \$400,000 mortgage. This business transaction decreases assets by the \$100,000 of cash disbursed, increases assets by the new \$500,000 building, and increases liabilities by the new \$400,000 mortgage.

## Limits of the Accounting Equation

Equity represents the portion of company assets that shareholders or partners own. In other words, the shareholders or partners own the remainder of assets once all of the liabilities are paid off. Incorrect classification of an expense does not affect the accounting equation. Understanding how the accounting equation works is one of the most important accounting skills for beginners because everything we do in accounting is somehow connected to it. Metro Corporation collected a total of \$5,000 on account from clients who owned money for services previously billed.

Accounting equation describes that the total value of assets of a business entity is always equal to its liabilities plus owner’s equity. This equation is the foundation of modern double entry system of accounting being used by small proprietors to large multinational corporations. Other names used for this equation are balance sheet equation and fundamental or basic accounting equation. Thus, the accounting formula essentially shows that what the firm owns (its assets) has been purchased with equity and/or liabilities.

## How to use the Accounting Equation

During the month of February, Metro Corporation earned a total of \$50,000 in revenue from clients who paid cash. The accounting equation is fundamental to the double-entry bookkeeping practice. Revenues and expenses are often reported on the balance sheet as “net income.” Receivables arise when a company provides a service or sells a product to someone on credit.