What Is Accounting Equation?

The accounting equation is an essential part of the balance sheet and one of the basic principles of financial accounting. To understand what accounting equation is, you need to first know what a balance sheet is.

A balance sheet is one of the three fundamental financial statements, alongside income statement and the cash flow statement. It shows a business’s total assets and how each of the assets are financed.

According to Investopedia, the accounting equation ensures that the balance sheet remains accurate. That is, each entry made on the debit side has a connected entry (or coverage) on the credit side.

Accounting equation implies: Assets = Liabilities + Shareholder’s Equity

This equation establishes the foundation of double-entry accounting, also known as double-entry bookkeeping, and highlights the balance sheet structure. Every transaction in double-entry accounting affects at least two accounts.

The accounting equation is also known as the basic accounting equation or the balance sheet equation.

Rearranging Accounting Equation

The accounting equation can also be rearranged into the following form:

Shareholder’s Equity = Assets – Liabilities

In this form, it is simple to show the relationship between shareholder’s equity and debt (liabilities). As you can see, shareholder’s equity is what is left after liabilities have been subtracted from assets. This is because creditors – parties that lend money such as banks – have the first claim to a company’s assets.

For example, if a company becomes bankrupt, its assets are sold and these funds are used to pay off its debts before any other thing. When the debts are cleared, shareholders can now move to claim any of the company’s assets to attempt to recover their investment.

Regardless of how the accounting equation is represented, it is important to remember that the equation must always balance.

Examples Of Accounting Equation

The accounting equation provides a balance for both sides of the equation. Let’s take a look at some samples of transactions and how they affect the accounting equation.

Example 1 – Purchasing a Machine with Cash

Company ABC wishes to purchase a $500 industrial machine using only cash. This transaction would result in a debit (an increase in an asset) to Equipment (+$500) and credit (a decrease in an asset) to Cash (-$500). The net effect on the accounting equation would be as follows:

Accounting Equation Machine Purchase Cash

This type of transaction affects only the assets of the equation; therefore there is no connected effect on liabilities or shareholder’s equity on the right side of the equation.

Example 2 – Purchasing a Machine with Cash and Credit

Company ABC wishes to purchase a $500 industrial machine but it only has $250 of cash in its holdings. The company is allowed to purchase this machine with an initial payment of $250 but it owes the manufacturer a balance of $250. It would result in a debit (an increase in an asset) to Equipment (+$500), a credit (an increase in a liability) to Accounts Payable (+$250), and a credit (a decrease in an asset) to Cash (-$250). The net effect on the accounting equation would be as follows:

Accounting Equation Machine Purchase Credit

This transaction affects both sides of the accounting equation; both the left and right sides of the equation increase by +$250.

A Deeper Understanding Of Accounting Equation

Every business’s financial position is based on three key components of a balance sheet: assets, liabilities, and owner’s equity or shareholder equity.

The accounting equation is a clear representation of how these three important components are associated with each other.

The assets represent the company’s valuable resources, whereas the liabilities represent its obligations. Both liabilities and shareholders’ equity represent how a company’s assets are financed. If it is financed with debt, it will be recorded as a liability, but if it is financed by issuing equity shares to investors, it will be recorded as shareholders’ equity.

The accounting equation helps to assess whether the business transactions carried out by the company are properly documented in its books and accounts.

How To Calculate Accounting Equation

The formula for calculating the accounting equation is Assets=(Liabilities+Owner’s Equity)

In the balance sheet, you will find the elements that contribute to the accounting equation. To do this, you need to:

Locate the company’s total assets on the balance sheet for the period.
Total all liabilities, which should be a separate listing on the balance sheet.
Locate total shareholder’s equity and add the number to total liabilities.
Total assets will equal the sum of liabilities and total equity.

For instance, the leading retailer, ABC Corporation reported the following on its balance sheet for its latest full fiscal year:

Total assets: $200 billion
Total liabilities: $150 billion
Total shareholders’ equity: $50 billion

If we calculate the right-hand side of the accounting equation (equity + liabilities), which is ($50 billion + $150 billion) = $200 billion, which corresponds to the value of the assets reported by the company.

Importance of Accounting Equation

For those of you that may want to ask what does accounting equation do to the books, here’s the perfect answer.

The accounting equation is significant because it provides a clear picture of your company’s financial situation. It is the financial reporting standard and the foundation for double-entry accounting. You cannot read your balance sheet or understand your financial statements without the balance sheet equation.

Your accounting equation provides answers to questions like:

Do you have enough assets to purchase more machines or new office space?
Should you take out a business loan (increase both liabilities and assets) to make purchases for your business?
Do you have enough revenue (assets) to pay down your liabilities?

Summarily, a balance sheet equation otherwise known as the accounting equation solves important financial questions for your business. It is used in setting budgets and making final decisions.

What Is Expanded Accounting Equation?

The expanded accounting equation illustrates the relationship between your balance sheet and income statement. Revenue and owner contributions are the two primary sources that create equity.

The expanded accounting equation is:

Assets = Liabilities + Owner’s Equity + Revenue – Expenses – Draws

Revenue is your business earnings through standard operations. Expenses are the costs to provide your products or services.

In the expanded accounting equation, various transactions have an effect on the owner’s equity. Revenue increases the owner’s equity, whereas draws and expenses (such as rent payments) decrease the owner’s equity.

Both sides of the equation must be balanced. If the expanded accounting equation on both sides is not equal, your financial reports are incorrect.

Is The Accounting Equation Different from the Working Capital Formula?

The accounting equation uses total assets, total liabilities, and total equity in the calculation while working capital measures liquidity by misusing Current Assets from Current Liabilities.

Cash and cash equivalents, accounts receivable, inventory, and prepaid assets are examples of current assets. Current liabilities are financial obligations that are due in cash within a year. Accounts payable, accrued expenses, and the short-term portion of the debt are examples of current liabilities.

Lastly, just like the accounting equation, working capital indicates whether a company will have the amount of money needed to pay its bills and other obligations when due.

Are There Limitations To The Accounting Equation?

One major limitation of the accounting equation is that it does not show investors how well a company is performing. Before an investor comes into a company, they carefully interpret the numbers and decide for themselves whether the company has too many or too few liabilities, not enough assets, or perhaps too many assets, or whether its financing is enough to drive its long-term growth.

FAQs On Accounting Equation

What is the accounting equation?

The accounting equation is a fundamental accounting principle that states that an entity’s total assets must equal its total liabilities plus equity. This equation is used to ensure the accuracy of a company’s financial statements.

Why is the accounting equation important?

The accounting equation helps businesses form the foundation of all financial statements. The income statement, balance sheet, and statement of cash flows can all be derived from this one simple equation. Furthermore, the accounting equation helps to guarantee that a company’s financial statements are correct.

What are the 3 elements of the accounting equation?

The three elements of the accounting equation are assets, liabilities, and equity. These three elements are all vital for comprehending a company’s financial position.

What is the basic accounting equation formula?

The basic accounting equation formula is Assets = Liabilities + Equity. This equation states that the total value of an entity’s assets must equal the total value of its liabilities plus its equity. It is this simple equation that forms the foundation for all financial statements.

References

corporatefinanceinsititute.com – Accounting Equation
freshbooks.com – What Is The Accounting Equation
investopedia.com – Accounting Equation
patriotsoftare.com – The Math Behind the Accounting Equation
tipalti.com – Accounting Equation Explained

What Is Accounting Equation?

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