The accounting equation represents the basic equation associated with double-entry accounting. Essentially, this equation establishes the formula for representing the relationship that exists between assets, liabilities, and net worth. As the most common of all balance sheet equations, the accounting equation is also fundamental to learning how to properly read and utilize a balance sheet.
For the purposes of understanding how the accounting equation works, it is important to have some grasp of what is meant by each of the three basic components mentioned in the equation. Assets refer to the worth of goods or products in the possession of the owner. Liabilities represent the amount of cash or resources that were borrowed in order to acquire the assets. Net worth is the financial worth of the individual, less any outstanding debts to outside entities. Essentially, the point of the accounting equation is to arrive at this final component of net worth, or as it is sometimes referred to, the equity.
To illustrate the way that this equation works to determine net worth, assume that an investor currently has a net worth of two thousand dollars, with no current liabilities. The owner chooses to acquire a new asset for the amount of one thousand dollars. In order to acquire the asset, the owner chose to use five hundred dollars of assets that were already in his or her possession, and then borrow five hundred dollars to complete the purchase. Assuming there is no depreciation associated with the acquired asset, the owner now has control of assets worth a total of three thousand US Dollars (USD). However, he or she now has liabilities in the amount of five hundred USD. This will result in a net worth of two thousand, five hundred USD. As long as the sum of the net worth and the liabilities equal the assets, all is well in 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 use of the accounting equation as the foundational balance sheet equation, this means that the bottom line on the balance sheet will always show the net worth of the individual or entity. As long as the final net worth figure and the amount of liabilities balance with the assets, all is well. However, if the combination of liabilities and net worth does not equal the total of the assets, there is something wrong in the accounting process, and an investigation to uncover the origin of the imbalance should take place immediately.