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The accounting equation used in business must always be kept in balance — the assets on one side of the equation must equal the claims against the assets on the other side:
Assets = Liabilities + Owners’ equity
These claims arise from credit extended to the business (liabilities) and capital invested by owners in the business (owners’ equity). The claims of liabilities are significantly different than the claims of owners; liabilities have seniority and priority for payment over the claims of owners.
Suppose a business has $10 million total assets. The money for the assets came from somewhere. The business’s creditors (to whom it owes its liabilities) may have supplied, say, $4 million of its total assets. Therefore, the owners’ equity sources provided the other $6 million.
The assets on the balance sheet consist of things of value that the company owns or will receive in the future and which are measurable. Liabilities are what the company owes, such as taxes, payables, salaries and debt. The equity sections displays the company's retained earnings and the capital that has been contributed by shareholders.
The balance between assets, liability and equity makes sense when applied to a simpler example, such as buying a car for $10,000. In this case, you might use a $5,000 loan (debt), and $5,000 cash (equity) to purchase it. Your assets are worth $10,000 total, while your debt is $5,000 and equity is $5,000. In this simple example, assets equal debt plus equity.
The major reason that a balance sheet balances is the accounting principle of double entry. This accounting system records all transactions in at least two different accounts, and therefore also acts as a check to make sure the entries are consistent.
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Dec 1st, 2015
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