The accounting equation is the Foundation of double entry system of accounting.

An accounting equation is based on the Dual Aspect Concept of Accounting, according to which, every transaction has two aspects Debit and Credit.

 

The accounting equation is expressed as: Assets = Liabilities + Shareholders’ Equity

 

The total assets of the business firm are financed through the funds raised from either the outsiders or the owners. Thus, at any point of time, the total assets of a business are equal to its total liabilities. Liabilities to outsiders are known as outsider’s liabilities but liability to the owners is referred to as Capital or Owner’s equity. The relationship between assets, liabilities and the capital can be expressed in the form of an accounting equation as follows:

  • Asset = Capital + Liabilities
  • Liability = Asset-Capital
  • Capital = Assets-Liabilities

You can see this relationship between assets, liabilities, and shareholders’ equity in the balance sheet, where the total of all assets always equals the sum of the liabilities and shareholders’ equity sections.

The accounting equation will always tally if double-entry system of accounting is followed correctly.The accounting equation is used to understand and analyse the effect of the relationship of financial activities within a business.