The accounting equation is a formula that represents the relationship between the assets, liabilities, and owner’s equity of a small business. Businesses use this to basically show what it owns what it owes and what its investors are investing. In order to understand these concepts it is important to have some knowledge of what is meant by each of the three basic components mentioned. “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. ”(M. Tatum 2013). These things are important because this is what makes a business of any size thrive. Business need to know these things so that it may make decisions about its future to determine whether or not it has the potential to be successful and prosper in the future or if they should take an alternate route to better their business practice. The balance Sheet plays a role in the accounting equation by giving a brief picture of the company’s financial state at a point in time.
The balance sheet will represent the accounting equation for a company Assets = Liabilities + Owners’ Equity stated more simply, the dollar total of the assets equals the dollar total of the liabilities plus the dollar total of the owners’ equity. The balance sheet presents a company’s resources, what they have what they owe and what is invested in them. For example, say a company has an increase of $1,000 to its assets since the owner decided to invest more money into his business. This increase to assets represents an equal increase to the amount of money the company owes to the owner (equity).
Thus, the accounting equation will not remain in balance unless $1,000 is added to the company’s equity as well (QuickMBA, 2007). It is important to realize, though, that a transaction can affect only one side of the accounting equation. For instance, if a company chooses to purchase office supplies for $400 using cash, this will not affect the business’s liabilities or equity. Instead, it only represents the exchange of one asset for another (cash is decreased by $400, while office supplies increase by $400).
Finally, a transaction can cause more than two affects on the accounting equation. For example, say a retailer decides to buy a shipment of a new product for $1,000. This causes an automatic increase of $1,000 to inventory (an asset). However, instead of paying for this shipment with only cash, the company decides to pay $500 up front and purchase the rest on credit. As a result, cash is only decreased by $500 and liabilities are increased by $500, thus causing three changes to the accounting equation (Money Instructor, 2005).