The accounting equation is Assets = Liabilities + Owner's (Stockholders') Equity. The accounting equation should remain in balance at all times because of double-entry accounting or bookkeeping. (Double-entry means that every transaction will affect at least two accounts in the general ledger.)
Here are some examples of how the accounting equation remains in balance. An owner's investment into the company will increase the company's assets and will also increase owner's equity. When the company borrows money from its bank, the company's assets increase and the company's liabilities increase. When the company repays the loan, the company's assets decrease and the company's liabilities decrease. If the company pays cash for a new delivery van, one asset (cash) will decrease and another asset (vehicles) will increase. If a company provides a service to a client and immediately receives cash, the company's assets increase and the company's owner's equity will increase because it has earned revenue. If the company provides a service and allows the client to pay in 30 days, the company has increased its assets (Accounts Receivable) and has also increased its owner's equity because it has earned service revenue. If the company runs a radio advertisement and agrees to pay later, the company will incur an expense that will reduce owner's equity and has increased its liabilities.
From our examples, you can see that owner's equity increased when the owner made an investment in the business and also when revenues were earned. Owner's equity decreased when the owner withdrew assets from the business and when expenses were incurred. This leads us to the expanded accounting equation:
Assets = Liabilities + Owner's Equity + Revenues – Expenses – Draws
Sample Accounting Equation Questions
1) Liabilities are amounts _______ by a company.
2) The collection of an account receivable will affect two _________ accounts.
3) Double-entry accounting is a key reason why the accounting ______________ remains in balance.
4) Along with owner's equity these are claims against a company's assets.
5) This word is often part of the account title of liabilities.
6) The accounting equation remains in balance because of the accounting system known as __________-entry.
7) The financial statement with a structure similar to the accounting equation is the __________ sheet.
8) Revenues + gains – expenses – losses = _____ income.
9) The balance sheet reports the financial position of a company at a moment or ________ in time.
10) A listing of all the accounts to which amounts can be posted is the ___________ of accounts.