Understanding the Accounting Equation and the role of Debit & Credits

Whether you are a business owner, a finance enthusiast, or just curious about how companies keep their financials in check, the accounting equation is the foundation of it all.

At its core, accounting is a language - and like any language, understanding its grammar is key. The accounting equation is that grammar.

The Accounting Equation

The accounting equation is:

Assets = Liabilities + Owner’s Equity

This simple yet powerful formula is the bedrock of double-entry accounting. It ensures that every financial transaction keeps the books in balance. If a business buys equipment (an asset) by taking a loan (a liability), both sides of the equation increase equally. When an owner invests in their business, equity increases, and so do the assets.

Think of it this way:

• Assets are what the business owns.
• Liabilities are what the business owes.
• Owner’s Equity is the owner’s share after liabilities are subtracted.

Maintaining this balance is not just a theoretical concept - it’s how businesses stay financially healthy and transparent.

Debits and Credits: The Balancing Act

To keep this equation balanced, every transaction affects at least two accounts - this is called double-entry accounting. One side is a debit, and the other is a credit.

Here’s a quick guide to remember how they work:

For example, when a company pays rent (an expense), it debits the Rent Expense account and credits Cash. The equation remains balanced.

Debits and credits aren't about “good” or “bad”, they are simply accounting tools to record the flow of money.

Why It Matters

Understanding the accounting equation and how debits and credits work gives insight into how financial information is structured, helping individuals and businesses make informed decisions. Whether you are reading a balance sheet, making a journal entry, or budgeting for the future, these principles form the compass for sound financial navigation.

This article was written by Arpita Darji. Arpita is an Accounting Specialist with Baldwin CPAs. For more information on the support Baldwin CPAs can provide you, contact arpita.darji@baldwincpas.com.