The accounting equation shows the relationship between assets, liabilities, and net worth in double-entry bookkeeping. Net worth is determined by subtracting liabilities from assets. The equation is critical for understanding balance sheets and ensuring accurate accounting.
The accounting equation represents the basic equation associated with double-entry bookkeeping. Essentially, this equation establishes the formula to represent the relationship that exists between assets, liabilities and net worth. As the most common of all balance sheet equations, the accounting equation is also critical to learning how to read and correctly use a balance sheet.
To understand how the accounting equation works, it is important to have an idea of what each of the three basic components mentioned in the equation means. Assets refer to the value of goods or products in the possession of the owner. Liabilities represent the amount of cash or resources that were borrowed to acquire the assets. Net worth is the individual’s financial wealth, minus outstanding debts to outside entities. Essentially, the goal of the accounting equation is to arrive at this final component of net worth, or as it is sometimes called, net worth.
To illustrate how this equation for determining net worth works, suppose an investor currently has a net worth of $2,000, with no current liabilities. The owner chooses to purchase a new asset in the amount of one thousand dollars. To acquire the asset, the owner elected to use $500 of assets already in the owner’s possession, and then borrow $500 to complete the purchase. Assuming there is no depreciation associated with the acquired asset, the owner now has control of the assets with a total value of three thousand United States dollars (USD). However, he or she now has liabilities in the amount of $500. This will result in a net worth of two thousand five hundred USD. As long as the sum of net worth and liabilities equals assets, all is well with the accounting process.
Simply speaking, the accounting equation illustrates that net worth is determined by taking the value of current assets in hand and subtracting the value of any current liabilities. When it comes to the use of the accounting equation as the basic balance sheet equation, this means that the bottom line of the balance sheet will always show the net worth of the person or entity. As long as the final net worth number and the number of liabilities balance with the assets, all will be well. However, if the combination of liabilities and net worth does not equal total assets, there is something wrong with the accounting process, and an investigation to discover the source of the imbalance must be carried out immediately.
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