The two foundational principles of bookkeeping are the Accounting Equation and the Double-Entry Concept.
The accounting equation represents the relationship between assets, liabilities and capital of a business. In its simplest form, it is expressed as :
Equity {Owner’s capital} = Assets – Liabilities
Equity/capital is defined as the residual interest in the remaining assets that belong to the business owner after paying off all the liabilities.
For example, let’s say that your business owns a property that is worth $1 million. However, you have an outstanding mortgage of $200 000 on that property. That means that if you sell the property, you are obliged by law, to pay off the bank loan first. And the remaining $800 000 belongs to you as the business owner’s equity interest. That is how the concept of equity works.
The accounting equation can be rearranged in many ways. The most common form is :
Assets = Equity + Liabilities
In this format, the formula shows that the assets controlled by the business are funded by loans and owner contributions.
How do we define the elements of the accounting equation ?
Assets, in simple language means things that are owned by the business for example, machinery, vehicles, property, cash, accounts receivable, trademarks etc. It represents items that will create an inflow of economic benefits from using it.
Liabilities on the other hand, represent money that your business owes to third parties. This can be in the form of bank loans, accounts payable, taxes payable and wages payable. It represents items that will cause an outflow of economic resources when you settle the obligation.
Equity as we defined earlier, is the leftover assets that remain after you pay off all your liabilities.
