Reviewed by Oct 05, 2020| Updated on
The basic equation of accounting reflects the dual-entry concept of claims, i.e. of the owner's claims and those of outsiders. The accounting equation is thus expressed as
*Assets = Liabilities + Capital *
The accounting equation states that enterprise's assets are, therefore, equal to the owners and outsider's claims. This ensures that a company's finances will correlate with the outsider's claims at any point in time. These outsiders are those who are offered funding to fund those resources.
In general, the owners and outsiders provide the resources in the company. The owners' claim is referred to as 'capital', whereas outsider's claims are referred to as 'liabilities.' Since every part of this equation relates to the balance sheet, this equation also states a company's financial condition at a given date. That is to suggest that in some way or the other, any business transaction impacts a company's balance sheet.
To explain how this equation impacts a company's balance sheet, let's consider each of its components:
Assets: The assets are the economic resources that a business organisation holds that are of interest to the business. The company uses these tools in its activities and is generally known as current assets and noncurrent assets.
Liabilities: These are liabilities or debts a business may have to pay in the future at some stage. That means these are the representations a business organisation owes both to its owners and outsiders. Also, liabilities are generally divided into current liabilities and long-term liabilities, as are properties.
Shareholders Capital: It refers to the amount that the company owner spends in the business. The owner can carry the capital in the form of cash or assets. So capital is an obligation and a demand on the company's assets. Hence, it is displayed on the balance sheet's liability side.
So a company's assets will always be equal to others' liabilities or claims at any point in time because of the double-entry principle, which states that each transaction has a debit in one account and a credit in another.