Definition: The balance sheet equation or accounting equation is the most basic, fundamental part of accounting. The balance sheet equation forms the building blocks for the entire double entry accounting system. The balance sheet equation looks like this. Asset = Liabilities + Equity.
What Does Balance Sheet Equation Mean?
In its most basic form, the balance sheet equation shows what a company owns, what a company owes, and what stake the owners have in the business. The equation starts off with the company assets. These are the resources that the company has to use in the future like cash, accounts receivable, and fixed assets.
Most of the time, the company doesn’t own its assets outright. For instance, it might have a loan on the company car, a mortgage on the building, or even owe money to its shareholders. That is why the second part of the balance sheet equation is made up of the claims on company assets. All of these claims on the company assets are separated into two categories: liabilities and equity.
Liabilities are claims on the company assets by other firms or people. A bank loan or mortgage is a good example. The bank has a claim to the business building or land that is mortgaged. Liabilities are usually shown before equity in the balance sheet equation because liabilities must have to be repaid before owners’ claims.
Equity on the other hand is the shareholders’ claims on the company assets. This is the amount of money shareholders contributed to the company for an ownership stake. Equity also includes retained earnings. Once all of the claims by outside companies and claims by shareholders are added up, they will always equal the total company assets.