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What is the accounting equation?

The accounting equation is Assets = Liabilities + Owner's Equity. This is the same format used in a sole proprietorship's balance sheet. (A corporation's balance sheet will use Stockholders' Equity instead of Owner's Equity.)

The accounting equation will always remain in balance if double-entry accounting is followed accurately. For example, if a company borrows $10,000 from its bank, Assets increase by $10,000 and Liabilities increase by $10,000. When a company buys inventory with cash, one Asset (Inventory) increases and one Asset (Cash) decreases. If the owner invests $5,000 of personal assets in the business, the company's Assets increase and Owner's Equity increases. If the owner withdraws $2,000 from the business for her personal use, the company's Assets decrease and Owner's Equity decreases.

Revenues causes Owner's Equity to increase, and expenses cause Owner's Equity to decrease. If the company earns $1,500 in service fees, the company's Assets (Cash or Accounts Receivable) will increase and Owner's Equity will increase. When the company incurs electricity charges, the company's Liabilities increase and Owner's Equity decreases. If the company pays for ads to appear in this week's newspaper, Assets decrease and Owner's Equity decreases.

Bookkeepers and accountants will be entering amounts into two or more accounts for every transaction. This occurs with business accounting software as well, but the software might be doing part of the entries behind the scenes.