Accounting equation is formula representing three factors: Asset , liability and capital.
Accounting equation is always remained in balance for each transaction of business.
Before understanding accounting equation, first we need to understand what is assets, liability and capital?
Assets: assets are property of business like land, building, furniture, machinery, plot, debtors, stock , cash, bank etc. Through asset, business will gain any future benefit or gain.
Liability: liability is debt of business like creditors, loans from bank, outstanding expenses etc.
Capital: Capital is owner's equity or investment in business. Revenue: Revenue is income of business and it will increase capital.
Expenses: Expenses are day to day cost of running business. When we reduce liability from asset, it will be business capital. We can understand it with following examples.
Xoya has started business with $500000. Now, let’s make accounting equation for this transaction.
Xoya is owner of business so owner's equity is $500000. Other side, as she started business with cash, cash balance is $500000. So asset is $500000.
Equation is
$500000- 0 = $500000.
Xoya has sold service to peter at $5000. Peter has not paid yet. In this transaction, Xoya has sold service so income will increase by $5000. Similarly capital will be increased by $5000.
Other side, Debtor ( Peter) balance will be increased by $5000. Equation is
$5000- 0 = $5000.
Xoya has paid $1000 as salary.
In this transaction, salary (Expense) will be increased which will reduce the profit and capital by $1000. Other side cash will be reduced by $1000.
Equation is
-$1000 - 0 = -$1000.
Accounting equation can be used to do journal entry or understand transactions easily. Accounting equation is 100% accurate and it never varies for any transaction.