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What is Accounting Equation – Meaning, Formula and Calculation with Example
17 November 2022
Regardless of the size of the company, financial statements are created using a basic accounting equation. For a uniform international framework, this accounting equation is utilised everywhere. What exactly is the accounting equation and what purpose does it serve? Read on to find out!
What is Accounting Equation?
The accounting equation, also known as the balance sheet equation, essentially shows the relation between a firm’s assets, liabilities and the shareholders’ or owner’s equity.
It displays how a company’s resources (displayed as assets on the balance sheet) are distributed. On the left side of the equation are the company’s assets and the liabilities and equity (the total claims against those assets) are on the right.
The equation shows that creditors or owners are responsible for providing all of a company’s resources – through liabilities and equity.
Importance of Accounting Equation
The basic accounting equation depicts the relationship between the three items on a balance sheet—assets, liabilities and equity. When everything else is equal, a company’s equity will rise along with its assets, and vice versa. Equity drops if liabilities increase. However, equity rises if liabilities decrease – such as by paying off debt. Modern accounting techniques are based on these fundamental ideas.
What is Assets, Liabilities and Shareholder’s Equity in Accounting Equation?
It’s essential to properly define assets, liabilities, and equity to calculate the accounting equation’s outcomes.
An asset is anything with an economic value over which your company owns. This includes cash, intangible assets (like patents and copyrights), and tangible assets (like real estate, equipment, inventory, etc.)
A liability is a monetary obligation that your company must fulfil. While some liabilities include debt, others are often a necessary component of your core business activities. This includes salaries, taxes, and payments for credit cards and/or leases.
Liabilities are generally of two types. Current liabilities, often known as short-term liabilities, are due within a year. Long-term liabilities have maturities that are at least a year away.
3. Shareholder’s Equity
The company’s overall value is expressed in monetary terms. In other words, the sum would be left over after the firm sold all of its assets and settled all of its debts.
Types of Accounting Equations
The various types of basic accounting equations are as follows:
1. Asset = Liability + Capital
This balance sheet equation shows that all of the assets held by the firm are either financed with owner’s equity or the amount that the company owes to third parties, such as suppliers or lenders.
2. Liabilities= Assets – Capital
The difference between the assets and the owner’s investment in the business is what the firm owes to its lenders and others.
Businesses can ensure that their financial accounts are balanced using this straightforward accounting equation formula. A balance sheet should always have a corresponding entry on the credit side for every entry made on the debit side.
Accounting Equation Calculation:
Based on a company’s balance sheet, the accounting equation is calculated in the following manner:
1. Consider a company’s value of assets from its balance sheet for a specific period
2. Consider the company’s total liabilities, which will be listed separately in the balance sheet
3. Add the total liabilities and total stockholders’ equity
4. The company’s assets will then equal the sum of its liabilities and equity
Examples of Calculating Accounting Equation
Consider the following accounting equation example of Rosé Ltd.
Rosé Ltd. made the following transactions in a particular year-
1. Purchased inventory worth Rs.50,000 from ABC suppliers.
2. Sold shares worth Rs.2 lakh to an investor
The transactions are as follows:
50,000 (payable to supplier)
Sample Accounting Equation Transactions
Rosé Ltd. purchases raw materials worth Rs.6000 on credit. This increases their assets by Rs.6000 and also their liabilities by Rs.6000. This can be shown as:
Rosé Ltd. purchases a machine worth Rs.50,000 using both cash and credit. They decide to pay Rs.25,000 using cash and the rest would be purchased on credit. As a result, the assets side will increase by Rs.50,000 but will also reduce by Rs.25,000 due to the cash payment. On the other hand, the liabilities side will also increase by Rs.25,000 due to the credit purchase. This can be shown as-
Rosé Ltd. pays dividends worth Rs.75,000 to its investors. As a result, both the cash (asset) account and the retained earnings (equity) account decrease. This can be shown as-
Accounting Equations’ Rules
There are two basic fundamentals of the accounting equation. They are-
The balance sheet always balances out.
This means that assets are always equal to the sum of liabilities and owner’s equity.
Total debits are always equal to the total credit.
This means that the debit and credit amounts should be the same for every event that affects the books.
What is Accounting Equation Used For?
The accounting equation is the basic foundation of the double-entry system of accounting. Every business transaction requires two distinct accounting entries in the double-entry system. The equation helps to reinforce the same. It ensures that all sources of capital, i.e., assets, remain equal to all uses of capital, i.e., debt and equity.
Apart from this, the accounting equation offers an easy approach to checking the accuracy of a company’s bookkeeping. Not only that, but it also helps determine the firm’s profitability level. For instance, if the assets outweigh the owner’s equity and the liabilities, it can be a good indicator of the company’s financial health. This information is particularly useful for potential lenders and investors as they use it to deem the company’s creditworthiness.
Limitations of the Accounting Equation
The accounting equation has the following limitations:
The accounting equation does not offer a breakdown of how the business is run. Additionally, it doesn’t completely guard against accounting errors. In any case, there is still a possibility of an error that does not involve the accounting equation when the balance sheet report automatically updates.
The accounting equation is just intended to give the basic framework for creating the balance sheet. Any sort of transaction, including fraudulent ones, can be reported by an organisation as long as it adheres to the accounting equation. In other words, the accounting equation simply requires that information be recorded in an accounting system according to particular criteria, not that the reported financial information is accurate.
Accounting equation cannot inform investors of the performance of a company, Despite the fact that the balance sheet always balances. Investors must analyse the data and make their own judgments about the company’s financial health, including whether it has enough or too few assets, too many or too few liabilities, and if its finances are adequate to support long-term growth.
Accounting equation is a globally accepted equation that has brought about standardisation across various businesses. It is the basic foundation upon which the double-entry system of bookkeeping stands upon and shows a vague but overall picture of the relation between the company’s assets, liabilities and equity. Note that the accounting equation is not applicable for small firms which maintain a single-entry system of bookkeeping.
Q1. What is the double-entry system of bookkeeping?
Ans: This is a system where a record of transactions is made using double-entry as debits and credits. A sum of debits must equal the sum of credits since a debit in one account nullifies a credit in another account. For this, each transaction is recorded as two distinct accounting entries.
Q2. What is the accounting equation?
Ans: It is a basic accounting equation that states that the sum total of a company’s liabilities and equity is equal to its assets.
Q3. What is the formula of the accounting equation?
Ans: The formula is given as: Assets = Liabilities + Owner’s/Shareholders’ Equity
Q4. What are the components of the accounting equation?
Ans: The accounting equation has three basic components – assets, liabilities and owner’s/shareholders’ equity.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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