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At the core of accounting is the accounting equation, which expresses the relationship between what is owned by an entity (assets), and how these assets are financed (liabilities and equity).
A = L + E
In an equation, the left hand side of the equals sign must always equal the right hand side of the equals sign. In other words it must 'balance'. For example;
In accounting, this is where the term 'balance sheet' comes from. The total value of all assets must be equal to the total of the liabilities and equity of the firm. If one side increases, then the other side must also increase, and vice versa.
For example, imagine a business has liabilities of \$30,000 and equity of \$10,000. We can use this information to determine the total assets of the business.
A = \$30,000 + \$10,000
\$40,000 = \$30,000 + \$10,000
As we know that the left hand side of the equation must always equal the right hand side, we can also calculate the liabilities or equity.
For example, imagine a business has assets of \$20,000 and liabilities of \$15,000. To calculate the equity;
\$20,000 = \$15,000 + E
\$20,000 = \$15,000 + \$5,000
We found the value of the equity by subtracting the liabilities from the assets. You can learn more about rearranging equations in the next page.
It is very important to understand the accounting equation, as it allows us to ensure every business transaction has been accounted for correctly using the balance sheet.