Adhering to the basic accounting equation allows you have an accurate financial picture of your business activities, whether you need to create a balance sheet for your internal records or you’re seeking extra financing through a bank or investors. The basic equation states that total assets equals liabilities plus your equity as a business owner. This means the equation shows everything in your business that’s worth money equaling anything you owe to other people plus how much money you have invested in the company.
How the Accounting Equation Works
In a double-entry accounting system, for each entry in the general ledger you list a debit and a credit, ensuring the two are equal. A debit means you place the amount on the left side of the account, while a credit sits on the right side. When you increase an asset account, you have a debit entry. When you decrease an asset account, you have a credit entry. Conversely, for liabilities and owners’ equity, it is the opposite because those figures sit on the opposite side of the equation from the assets. So to increase a liability, you add a credit entry. And to decrease a liability, you add a debit entry.
Imagine your business takes out a $500 loan. You enter the cash as a debit and the debt as a credit. Both sides of the balance sheet come out equal. When you spend some of the money from the loan, you decrease the cash on your balance sheet and increase expenses.
A general accounting equation may look like this:
$5,000 in assets = $4,000 in liabilities + $1,000 of your money
To arrive at those sample figures, you to tally all of your assets, all of your debts, and all the money you have put into the company.
Double-Checking Your Numbers in the Accounting Equation
Run a trial balance to ensure that debits equal credits in your accounting equation. Create this report monthly or whenever you prepare your financial statements, such as income statements and balance sheets. If the two sides don’t balance, there’s an error you need to find among your listed accounts. When you use accounting software, the error may stem from someone not inputting an accurate number into the system. In general, robust and comprehensive accounting software reduces errors by automatically keeping accurate records of expenses, receipts, income, payroll, and invoicing.
Accounting software can minimize certain errors, such as simple mathematical mistakes or entering different debit and credit amounts for an entry. Run custom reports to ensure the numbers reflect what you expect when you see if your books are in balance.
Double-checking your numbers is vital when preparing financial statements. Banks and investors rely on these statements when making decisions about loaning money to your business. You also need accurate financial statements and reports when setting goals and assessing the overall health of your business. Keep your books accurate and up to date automatically. Change the way you manage your finances now.