What is the Balance Sheet Equation?
The balance sheet equation or accounting equation is the most basic, fundamental part of accounting. The balance sheet equation forms the building blocks for the entire double entry accounting system. The balance sheet equation looks like this.
Assets = Liabilities + Equity
On a company’s balance sheet, it shows that a company’s total assets are equal to the sum of the company’s liabilities and shareholders’ equity.
The balance sheet equation states that the sum of the assets should equal the sum of the liabilities plus the capital invested.
Based on this double-entry system, the balance sheet equation ensures that the balance sheet remains “balanced,” and each entry made on the debit side should have a corresponding entry (or coverage) on the credit side.
What Does Balance Sheet Equation Mean?
In its most basic form, the balance sheet 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, and fixed assets.
The financial position of any business, large or small, is assessed based on two key components of the balance sheet: assets and liabilities. Owners’ equity, or shareholders’ equity, is the third section of the balance sheet. The accounting equation is a representation of how these three important components are associated with each other. The accounting equation is also called the basic accounting equation or the balance sheet equation.
While assets represent the valuable resources controlled by the company, the liabilities represent its obligations. Both liabilities and shareholders’ equity represent how the assets of a company are financed. If it’s financed through debt, it’ll show as a liability, and if it’s financed through issuing equity shares to investors, it’ll show in shareholders’ equity.
The accounting equation helps to assess whether the business transactions carried out by the company are being accurately reflected in its books and accounts. Below are examples of items listed on the balance sheet:
Assets include cash and cash equivalents or liquid assets, which may include Treasury bills and certificates of deposit. Accounts receivables are the amount of money owed to the company by its customers for the sale of its product and service. Inventory is also considered an asset.
Liabilities are what a company typically owes or needs to pay to keep the company running. Debt, including long-term debt, is a liability, as are rent, taxes, utilities, salaries, wages, and dividends payable.
Shareholders’ equity is a company’s total assets minus its total liabilities. Shareholders’ equity represents the amount of money that would be returned to shareholders if all of the assets were liquidated and all of the company’s debt was paid off.
Balance Sheet Equation Example
Suppose a business reports $2.5 million in total assets. The total of its liabilities, plus the capital invested by its owners, plus its retained profit, adds up to $2.5 million. Otherwise, its books would be out of balance, which means there are bookkeeping errors.
Continuing with this example, suppose that the total amount of the liabilities of the business is $1.0 million. This means that the total amount of owners’ equity in the business is $1.5 million, which equals total assets less total liabilities. The total owners’ equity may be traceable to capital invested by the owners in the business as well as profit retained in the business. The total of these two sources of owners’ equity is $1.5 million.
The financial condition of the business in this example is summarized in the following accounting equation (in millions):
$2.5 assets = $1.0 liabilities + $1.5 owners’ equity
The Double-Entry System
The accounting equation forms the foundation of double-entry accounting and is a concise representation of a concept that expands into the complex, expanded, and multi-item display of a balance sheet. The balance sheet is based on the double-entry accounting system where the total assets of a company are equal to the total liabilities and shareholder equity.
Essentially, the representation equates all uses of capital (assets) to all sources of capital, where debt capital leads to liabilities and equity capital leads to shareholders’ equity.
For a company keeping accurate accounts, every single business transaction will be represented in at least two of its accounts. For instance, if a business takes a loan from a financial entity like a bank, the borrowed money will raise the company’s assets and the loan liability will also rise by an equivalent amount.
If a business buys raw material by paying cash, it will lead to an increase in the inventory (asset) while reducing cash capital (another asset). Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting.
The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left side value of the equation will always match with the right side value. In other words, the total amount of all assets will always equal the sum of liabilities and shareholders’ equity.
The global adherence to the double-entry accounting system makes the account keeping and tallying processes much easier, standardized, and fool-proof to a good extent. The accounting equation ensures that all entries in the books and records are vetted, and a verifiable relationship exists between each liability (or expense) and its corresponding source; or between each item of income (or asset) and its source.
- It helps to determine the credit on every debit in the books of accounts and vice versa.
- It makes it easier for the management to figure out the value of the third component of the accounting equation if they know the values of two other components.
- The accountants maintain accuracy in the practice of accountancy because of the accounting equation.
- It helps the management to track errors that occurred while preparing the financial statements.
- The Balance sheet equation does not provide the detailed effect of the transaction. It only matches the debts with the credits but fails to specify the reasons for the same.
- It focuses only on the items of personal and real accounts, not the items of nominal accounts. Nominal accounts include expenses and incomes of the business, and both expenses and incomes are not balance sheet items. So they are not a part of the accounting equation directly.
- It provides a basic understanding of the dual entry system of accounting but does not state the reason behind its use in accounting.
Limitations of the Balance Sheet Equation
The balance sheet equation always balances out the balance sheet, but it does not give the idea to the investor about the working of the company. For analyzing the performance, investors have to interpret numbers shown and performance whether the company has enough assets, whether liabilities are too much or too less and whether the company uses proper financing option to attain the growth in the long term.
- The two main components of the balance in any company which helps in knowing its financial position are assets and liabilities. The third section includes the shareholders’ equity or Owner’s equity.
- The balance sheet equation is also known as the accounting equation or basic accounting equation. It is the representation of the association of the three important components, assets, liabilities, and shareholders’ equity.
- The valuable resources that the company holds are its assets, and the obligation which the company has to others are its liabilities. The shareholders’ equity and liabilities show that how the financing of the company’s assets is done where financing through debt is represented as liability, and financing through the issue of equity shares is represented as shareholders’ equity.
- It provides the picture to the stakeholders of the company about whether the business transactions are shown accurately in the books and accounts.