One of the most fundamental principles in accounting is the accounting equation which represents the relationship between the assets, liabilities and equity of a company.
The equation is expressed as Assets = Liabilities + Equity.
This reflects the basic principle that the total value i.e. assets is funded either by borrowing, that is by creating liabilities or by the contribution of the owner which in simple terms is known as equity.
Consider the accounting equation as a balance scale. On one side, you have everything that is owned by the company which is known as the assets of the company. On the other side, you have everything the company owes which is referred to as liabilities plus the owner’s stake in the company which is referred to as equity. The two sides should always balance out. This equation indicates that what the company has is the sum total of what it owes and what is its own.
The accounting equation plays a vital role in microeconomics as well as macroeconomics. This helps in understanding and analyzing the financial position of any entity. Further this principle forms the basis of the double entry accounting system. Double entry accounting system is a widely used method used by businesses to keep their financial records accurate and balances. This equation is also the foundational basis for creating balance sheets and for financial analysis and planning.
For example, If a business has total assets worth Rs. 5,00,000 and its liabilities are worth Rs. 3,00,000, then the owner’s equity must be Rs. 2,00,000 for the accounting equation to balance.
In the same manner, when a company purchases a new equipment for Rs. 10,000 by taking a loan, its assets will increase by Rs. 10,000 for keeping the equation in balance.
Source: A to Z of Economics by Dr. NC Raghavi Chakravarthy