Accounting Equation
What Is It?
A business’s financial situation will change over time
![ae1](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae1.jpg)
For example, to start a business, the owner may deposit some of their own capital in the business’s bank account.
![ae2](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae2.jpg)
In addition to this, the owner may borrow money from a friend or relative.
![ae3](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae3.jpg)
The owner will deposit this money in the bank, as well
![ae4](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae4.jpg)
You will notice the system is always in balance.
![ae5](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae5.jpg)
This is because all money & value came from somewhere, and that money or value is used somewhere – or it went somewhere
![ae7](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae7.jpg)
This will be the case no matter what. For example, the owner may use some of the money to buy equipment or to pay for start up expenses.
![ae8](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae8.jpg)
It continues the same way over time. For example, the business may make sales.
![ae9](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae9.jpg)
If cash sales, the business will deposit the takings in the bank.
![ae10](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae10.jpg)
The business will use some of this money to pay for other expenses.
![ae11](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae11.jpg)
This process continues throughout the accounting period.
![ae12](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae12.jpg)
Then at period-end, you prepare period-end reports.
![ae13](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae13.jpg)
The income statement shows how the business performed during the period .
![ae14](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae14.jpg)
It shows income, expenses, and profit for the period.
![ae15](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae15.jpg)
Once prepared, you transfer profit to retained earnings.
![ae16](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae16.jpg)
After this, you prepare a balance sheet.
![17.2](https://seeaccountingnow.online/wp-content/uploads/2022/05/17.2.jpg)
If the balance sheet balances when it contains net profit, it shows the profit shown on the income statement is correct.
![18.2](https://seeaccountingnow.online/wp-content/uploads/2022/05/18.2.jpg)
With computerized accounting, this will always be the case
![19.2](https://seeaccountingnow.online/wp-content/uploads/2022/05/19.2.jpg)
The computer will ensure your system is in balance at all times
![ae20](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae20.jpg)
However, in the days of manual accounting systems it was easy to make mistakes along the way.
![ae21](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae21.jpg)
To check for errors, after transferring net profit to retained earnings… you prepared a balance sheet.
![ae22](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae22.jpg)
you prepared a balance sheet.
![ae23](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae23.jpg)
To find out whether the balance sheet balanced or not, you applied the formula: Assets = Liabilities + Equity.
![ae24](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae24.jpg)
If the equation proved correct, then it showed the net profit calculation was correct.
![ae25](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae25.jpg)
However, if the equation didn’t balance it showed the calculated profit was incorrect
![ae26](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae26.jpg)
How It Worked In Practice
To prepare a balance sheet, you begin by recording assets,
![ae26.2](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae26.2.jpg)
then you record liabilities & equity
![ae27.2](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae27.2.jpg)
Next, you find total assets, and total liabilities & equity
![ae28.2](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae28.2.jpg)
If both totals are the same, it shows the balance sheet balanced
![ae29.2](https://seeaccountingnow.online/wp-content/uploads/2022/05/ae29.2.jpg)
© R.J. Hickman 2020