Definition of Accounting Equation
The accounting equation of a sole proprietorship is assets = liabilities + owner's equity. For a corporation, the accounting equation is assets = liabilities + stockholders' equity.
The accounting equation is similar to the format of the balance sheet.
The accounting equation will always remain in balance if the double entry system of accounting is followed accurately.
Example of the Accounting Equation
Let's assume that a person starts a new sole proprietorship business by investing $10,000. The new business will now have: $10,000 of assets = $0 of liabilities + $10,000 of owner's equity. Next, let's assume the company purchases equipment at a cost of $3,000 and signs a promise to pay the $3,000 within six months. Now the company's accounting equation will contain these amounts: $13,000 of assets = $3,000 of liabilities + $10,000 of owner's equity.
Next, let's assume the new company completes a service for another business and earns revenues of $1,500 and allows the business to pay in 10 days. This means the new company will have an account (or trade) receivable of $1,500 and will have an additional $1,500 of owner's equity. After this transaction, the accounting equation will show: $14,500 of assets = $3,000 of liabilities + $11,500 of owner's equity.