- The accounting equation tallies up the total assets, liabilities and equity value of the company. This equation forms the basis for the balance sheet, one of the primary financial statements. On the balance sheet, the company lists all the assets and creates a total for the assets. The company also lists each of the liabilities and equity accounts and creates a total for these accounts. This total must equal the total of the assets.
- Accountants use a system called double-entry accounting. Each financial transaction recorded impacts a minimum of two accounts. Each transaction affects each side of the accounting equation equally. If total assets increase because of a transaction, the total of liabilities and equity values also needs to increase. A transaction might increase one asset account and decrease a separate asset account without impacting the liabilities or equity accounts. The accountant records each transaction using debits and credits. Debits and credits represent increases and decreases in the accounts affected.
- A debit entry increases any account that appears on the left side of the accounting equation. These accounts include any assets owned by the company. For example, the accountant records an increase in inventory, an asset, with a debit entry. A debit entry decreases any account that appears on the right side of the accounting equation. These accounts include the liability and equity accounts. For example, the accountant records a decrease in accounts payable, a liability, with a debit.
- A credit entry increases any account that appears on the right side of the accounting equation. These accounts include the liabilities and equity accounts. For example, the accountant records an increase in bonds payable, a liability, with a credit entry. A credit entry decreases any account that appears on the left side of the accounting equation. These accounts include the asset accounts. For example, the accountant records a decrease in cash, an asset, with a credit.
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