Recording of business transactions is entirely based on accounting equations. According to dual concept of accounting; “every debit has a credit” effect on the financial position of the business. Hence accounting equation is an accounting formula expressing equivalence of assets and liabilities in every business transactions. It means, the total claims (those of outsiders and of the proprietors) will equal the total assets of the firm, the claims, also known as equities, are of two types:
(a) Owner’s Capital or equity and
(b) Liabilities or amounts due to outsiders.
We can say:
Assets = Equity (total claims); or
Assets -= Liabilities + Capital; or
Assets – Liabilities = Capital
The above is known as the accounting equation or the balance sheet equation. Its ordinary meaning is that at any point of time the total assets of a firm will be equal to the total claims and that the owner’s claim against the firm can be ascertained by deducting the amounts due to outsiders from the total assets. If there is any change in the amount of assets or of the liabilities, the owner’s claim or the capital is bound to change corresponding. If assets increase and liabilities do not, the capital will also increase; a reduction in the amount of assets or an increase in the amount of liabilities will mean a reduction in the amount of capital. Hence the assets of a business are always equal to the liabilities or capital.