Basic Accounting Equation Elements

The basic accounting equation elements are simple concepts you need to grasp in order to run a small business. Accounting is based on the concept that a balance must be maintained through debits and credits, resulting in an accurate reflection of the status of an account.

All accounting is based on the following elements remaining in balance:

Assets alone must equal liabilities and equity combined.

Because these two sides must remain in balance, basic accounting is referred to as dual-entry accounting.

The three basic elements are as follows:

Assets. Assets are the collateral a person or business possesses such as money, equipment and supplies.

Liabilities. A liability is anything owed by the individual or business, including loans to banks, bills to be paid to suppliers, wages paid to employees, rent and other overhead.

Equity. This is what the individual or business owns, such as profit from the business and investment paybacks, once the liabilities have been accounted for.

In other words, the basic accounting equation is founded upon what the business actually owns and what the business owes. These should always balance in the end. Therefore, if you know two pieces of the equation, you should be able to deduct the third piece of the equation.

Changes are made to this basic equation every day. The individual or business makes sales, expends money for supplies, overhead costs or wages. These changes must be reflected on all sides of the basic accounting equation.

Let's say your business borrowed money from the bank to get started. You borrowed $100,000. Your business now owns $100,000 (assets) and your business has $100,000 in liabilities to the bank. The equation is balanced.

Now let's say you invest in a studio for your business. You put down $75,000 to buy the studio space outright. Now you own a studio (worth $75,000) and own the $25,000 remaining. Your liability to the bank is still $100,000, so your equation is still in balance.

When the equation is out of balance, we introduce the concepts of profits and losses. Obviously, every business wants to see profits, not losses! You'll use the accounting cycle to record what happens within these basic equations.

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