The accounting equation used in business must always be kept in balance — the assets and expenses on one side of the equation must equal the liabilities, owner equity, and revenue on the other side:
Assets + Expenses = Liabilities + Owners’ equity + Revenue
Suppose a business has $10 million in total assets and expenses. The money for the assets and expenses 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 and revenue will have provided the other $6 million.
Business accounting is based on the two-sided nature of the accounting equation. Both assets and sources of assets are accounted for, which leads, quite naturally, to double-entry accounting. Double entry, in essence, means two-sided.
Following is an example of an accounting equation;
$200,000 Assets + $50,000 Expenses = $80,000 Liabilities + $80,000 Owners’ equity + $40,000 Revenue
If we look at the above example, Assets and Expenses equal $250,000 but Liabilities, Owner Equity, and Revenue only add up to $200,000!
Whoops! This accounting equation doesn’t balance, so clearly, something is wrong. Either liabilities, owner’s equity, or some combination of both is $50,000 too low, or the two items on the right-hand side could be incorrect, in which case total assets are overstated by $50,000. With an unbalanced equation such as this, the accountant definitely should find the error or errors and make appropriate correcting entries.
What this should look like to be correct is the following:
$200,000 Assets + $50,000 Expenses = $100,000 Liabilities + $110,000 Owner Equity + $40,000
Now the left side balances with the right side with both sides equal to $250,000!