The basic accounting formula is an equation that represents the relationship between assets, liabilities and an owner’s equity. This formula forms the building block or cornerstone for the double entry accounting system, and as is formulated as follows: Asset = Liability + Equity (Owner's Capital)
Assets refer to all of the resources on hand used in maintaining the operations of a business. Assets can be tangible or intangible. Relevant examples of tangible assets include land, buildings, equipment, office supplies, inventory and cash. Intangible assets include goodwill and patents. Assets are normally reported on the balance sheet at cost or lower.
Liabilities refer to the amount of money owed to outside people or firms, known as creditors. They represent claims on a company’s assets by creditors. Liabilities include loans payable, accounts payable, unearned revenue, notes payable and bonds payable, among others. In a balance sheet equation, liabilities are shown before equity because they must be repaid first.
Equity refers to the amount of resources or capital invested in a business by its ownership. It consists of net loss, retained earnings, net income, preferred stock, drawings and capital. An owner’s equity is the book value of a company. Simply put, it is assets minus liabilities.
The basic accounting equation must always balance. This means that total assets must always equal liabilities and equity combined. If the sides of this equation do not match, then there is an error that must be corrected before the issuing of financial statements.