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The Accounting Equation: Definition & Components

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  • 0:06 Accounting Equation
  • 0:56 Understand the Parts
  • 1:48 How It Works
  • 3:58 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

There are a few basic building blocks that form the foundation of accounting. One of those is the accounting equation. In this lesson, you will learn what makes up the accounting equation, its purpose, and how it works.

The Accounting Equation

Have you ever been to the circus and watched the high wire act? It amazes me how those men and women manage to walk across that thin wire stretched way above the ground. What also amazes me is that the thing they use to keep their balance is just a long pole. It's hard to believe, but did you know that an accountant and a tightrope walker have the same goal? It's true. They both work hard to keep something balanced. Where the tightrope walker uses the pole to maintain balance, the accountant uses a basic mathematical equation that is called the accounting equation.

The accounting equation, written as Assets = Liabilities + Owner's Equity, shows the relationship between the three major types of accounts found in the accounting world. When used correctly, it is a reliable tool in maintaining balance in company accounts.

Understanding the Parts

In order to understand the accounting equation, you have to understand its three parts. First are the assets. Assets are anything that a company owns. Good examples of assets are cash, land, buildings, equipment, and supplies. Money that is owed to a company by its customers, which is known as accounts receivable, is also an asset.

Liabilities are what a company owes. Things such as utility bills, land payments, employee salaries, and insurance - those are all examples of liabilities.

The last component of the accounting equation is owner's equity. Owner's equity is the amount of money that a company owner has personally invested in the company. Initial start-up cost of a company that comes from the owner's own pocket - that's a good example of owner's equity.

How it Works

Now that you understand the parts of the accounting equation, let's talk about how it works.

Ed owns a small dairy. Production has been good these last few years, so Ed decided to open up a country store to sell some of his homemade dairy products. He borrows $25,000 from the bank to build the store. Once built, the store has a value of $40,000. Ed also has to hire an employee to help him work the store. The employee's salary is $15,000 a year. In order to make the cheese, ice cream, and sweet cream that he plans on selling in the store, Ed purchases equipment. He makes the $10,000 equipment purchase with money that he takes from his own savings account. So, what are Ed's assets, his liabilities, and his owner's equity valued at? Are his accounts balanced?

Assets are what Ed owns. With the information that is given in the example, we see that Ed has a store that is valued at $40,000 and equipment that is valued at $10,000. Liabilities are what he owes. Looking back, we see that Ed owes the bank $25,000 and his employee $15,000. Owner's equity is the amount of money that a company owner has personally invested in the company. Ed invested $10,000 when he bought the new equipment.

In order to see if the accounts balance, we have to use the accounting equation. The accounting equation states that assets are equal to the sum of the total liabilities and owner's equity. Ed has $50,000 in assets ($40,000 + $10,000). His total liabilities equal $40,000 ($25,000 + $15,000). His total owner's equity is $10,000.

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