The Accounting Equation
Businesses start when one or more persons decide to form an organization in order to make a profit. These persons have to find money to acquire the assets that it needs. Some of the money will come from their own savings and other types of belongings. This is called capital and these assets now belong to the business, in other words the owner has given them to the business. Some of the money may also come from the bank or other individuals as loans to the business. The business owes these persons and so these are liabilities. All these values owned (assets) and owed (liabilities and capital) can be shown in the form of an equation, that is the Accounting Equation.
The equation can be shown as: Assets = Liabilities + Capital
This equation shows that to acquire assets a business must use funds from outside sources such as liabilities and capital.
(The equation may also be shown as: Liabilities = Assets - Capital) OR Capital =Assets – Liabilities)
Note that the double entry rules for liabilities and capital are the same but they are opposite to the rules for assets (see above). The double entry system allows us to keep the accounting equation always in balance.