What is the Accounting Equation?
Definition: The accounting equation or balance sheet equation forms the building blocks for the entire double entry accounting system. It shows that every asset owned by the company is equal to the claims (liabilities and equity) against the asset. The accounting equation looks like this:
Asset = Liabilities + Equity
- Assets: This is the value of the items that a company owns, they may be tangible or intangible but belong to the company.
- Liabilities: This is a term for total value that a company is required to pay in the short term or the long term.
- Shareholders’ Equity: Shareholders Equity is the amount of money a company has raised through its issue of shares. Alternatively, it is also the amount of retained earnings of a company. As the shareholders invest their money in the company, they are required to be paid with some amount of returns, which is why this is a liability in the company’s account books.
This equation sets the foundation of double-entry accounting and highlights the structure of the balance sheet. Double-entry accounting is a system where every transaction affects both sides of the accounting equation. For every change to an asset account, there must be an equal change to a related liability or shareholder’s equity account. It is important to keep the accounting equation in mind when performing journal entries.
In its most basic form, the accounting equation shows what a company owns, what a company owes, and what stake the owners have in the business. The equation starts off with the company assets. These are the resources that the company has to use in the future like cash, accounts receivable, equipment, and land.
What Does Accounting Equation Mean?
Most of the time, the company doesn’t own its assets completely outright. There are claims to these assets. For instance, the company might have a loan on the company car, a mortgage on the building, or even owe money to its shareholders. That is why the second part of the accounting equation is made up of the claims on company assets. All of these claims on the company assets are separated into two categories: liabilities and equity.
Balance Sheet and Income Statement
The balance sheet is also known as the statement of financial position and it reflects the accounting equation. The balance sheet reports a company’s assets, liabilities, and owner’s (or stockholders’) equity at a specific point in time. Like the accounting equation, it shows that a company’s total amount of assets equals the total amount of liabilities plus owner’s (or stockholders’) equity.
The income statement is the financial statement that reports a company’s revenues and expenses and the resulting net income. While the balance sheet is concerned with one point in time, the income statement covers a time interval or period of time. The income statement will explain part of the change in the owner’s or stockholders’ equity during the time interval between two balance sheets.
Liabilities are claims on the company assets by other companies or people. In other words, it’s the amount of money owed to other people. A bank loan or mortgage is a good example. The bank has a claim to the business building or land that is mortgaged.
Equity on the other hand is the shareholders’ claims on the company assets. This is the amount of money shareholders have contributed to the company for an ownership stake. Equity also includes retained earnings. Equity is usually shown after liabilities in the accounting equation because liabilities must have to be repaid before owners’ claims. You might also notice that the accounting equation is in the same order as the balance sheet.
Once all of the claims by outside companies and claims by shareholders are added up, they will always equal the total company assets.
The accounting equation is fundamental to the double-entry bookkeeping practice. Its applications in accountancy and economics are thus diverse.
A company’s quarterly and annual reports are basically derived directly from the accounting equations used in bookkeeping practices. These equations, entered in a business’s general ledger, will provide the material that eventually makes up the foundation of a business’s financial statements. This includes expense reports, cash flow, interest and loan payments, salaries, and company investments.
Double entry bookkeeping system
The accounting equation plays a significant role as the foundation of the double entry bookkeeping system. The primary aim of the double entry system is to keep track of debits and credits, and ensure that the sum of these always matches up to the company assets, a calculation carried out by the accounting equation. It is based on the idea that each transaction has an equal effect. It is used to transfer totals from books of prime entry into the nominal ledger. Every transaction is recorded twice so that the debit is balanced by a credit.
Income and retained earnings
The income and retained earnings of the accounting equation is also an essential component in computing, understanding, and analyzing a firm’s income statement. This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly. Thus, the accounting equation is an essential step in determining company profitability.
Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets.
However, due to the fact that accounting is kept on a historical basis, the equity is typically not the net worth of the organization. Often, a company may depreciate capital assets in 5–7 years, meaning that the assets will show on the books as less than their “real” value, or what they would be worth on the secondary market.
Due to its role in determining a firm’s net worth, the accounting equation is an important tool for investors looking to measure a company’s holdings and debts at any particular time, and frequent calculations can indicate how steady or erratic a business’s financial dealings might be. This provides valuable information to creditors or banks that might be considering a loan application or investment in the company.
- The accounting equation is considered to be the foundation of the double-entry accounting system.
- The accounting equation shows on a company’s balance sheet where the total of all the company’s assets equals the sum of the company’s liabilities and shareholders’ equity.
- Assets represent the valuable resources owned by the company.
- The liabilities represent their obligations.
- Both liabilities and shareholders’ equity represent how the assets of a company are financed.
- Financing through debt shows as a liability, and financing through issuing equity shares appears in shareholders’ equity.