The accounting equation: components, balance sheet relations, and transaction effects

¶ … Accounting Equation Works

The financial position of a business is represented by the components of the accounting equation (Lerner, 1987). The accounting equation is assets = liabilities + equity. Assets are items what the business owns that have value and are used in the operation of the business. Liabilities are what the business owes to others, such as creditors. And, equity is the interest of the shareholders, or owners.

The balance sheet reflects the accounting equation by reporting assets, liabilities, and equity at a specific period in time (Accounting Equation, 2013). The components of the balance sheet are assets, liabilities, and equity, the same as the accounting equation. On the balance sheet, liabilities and equity added together and must equal the total assets. If it does not equal, there is an error in balancing somewhere in the accounts or in the calculations of the balance sheet.

The components of the accounting equation affect each other each time a transaction takes place. Under double entry accounting, there must be a debit and a credit with each transaction. For example, for expenses that are paid with cash, the cash account (asset) is credited and the expense item (liability) is debited. The transactions to pay employees are recorded under the same concept. This is reversed when the business gets a loan. The cash account (asset) will be debited with incoming cash and the accounts payable (liability) will be credited. Transactions for buying equipment on credit is recorded under this same concept.