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!
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.
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.
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.
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.
The various types of basic accounting equations are as follows:
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.
The difference between the assets and the owner’s investment in the business is what the firm owes to its lenders and others.
The value of assets owned solely by owner equity can be calculated using this balance sheet equation.
The formula of the accounting equation is:
Assets = Liabilities + Shareholders’/Owner’s Equity
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.
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
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)
There are two basic fundamentals of the accounting equation. They are-
This means that assets are always equal to the sum of liabilities and owner’s equity.
This means that the debit and credit amounts should be the same for every event that affects the books.
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.
The accounting equation has the following limitations:
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.
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.
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.
Ans: The formula is given as:
Assets = Liabilities + Owner’s/Shareholders’ Equity
Ans: The accounting equation has three basic components – assets, liabilities and owner’s/shareholders’ equity.
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
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