The double-entry bookkeeping system has at its core the accounting equation. Simply put, the accounting equation states that assets equal liabilities plus owner's equity. For business, the owner's equity part is instead of shareholder's equity. Every single transaction your business makes will influence one part of the accounting equation. However, to properly utilize this equation, it's important to understand the key terms involved and how they relate to the equation.
The following are definitions of these key terms and how they relate to the accounting equation.
An asset is anything you or your business owns that possesses economic value. Examples of assets are cash, real estate, accounts receivable, inventory, office equipment, automobiles and other property. In the accounting equation, assets must equal liabilities plus shareholder equity for the books to balance. If your assets aren't equal in the equation, then you may need to recheck your accounting ledger.
Liabilities are what a business owes to another entity in the form of a financial obligation. Some examples of liabilities include accounts payable, wages, taxes, purchase of equipment, leases, pensions and other debt. The liabilities plus shareholder equity should be the same as the assets side of the accounting equation.
Shareholders' equity is total assets minus total liabilities. In the accounting equation, it is on the liabilities side of the formula. In other words, shareholders' equity is what remains when a company pays all its debt. Cash and retained earnings are the two sources of shareholders' equity. You'll also see shareholders' equity referred to as owners' equity, net assets, shareholders' funds and net worth.
Debits and credits
The term debit derives from the Latin word debitum, which essentially means "to owe." When referring to the accounting equation, the debit adds to the liability part of the formula. However, when you enter a debit into the formula, it requires a credit in the asset part of the accounting equation. Debits and credits are the backbone of the double-entry accounting system, which most companies use today.
Inventory is the cost to purchase or make merchandise for sale to the customer. In the accounting equation, you would consider any inventory an asset.
The balance sheet is a statement of financial position for a company and is a direct reflection of the accounting equation.