Accounting Equation

What is the Accounting Equation, and its importance with examples

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If your small business uses the double entry accounting system, you may have heard the term “accounting equation.”

What does this mean, and why does it matter to your business? Here’s a closer look at the accounting equation.

What Is the Accounting Equation?

The accounting equation is considered to be the foundation of the double-entry accounting system.

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.

Based on this double-entry system, the accounting 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.

Related : The Role Of Accounting In Business And Why It’s Important

What Is the Accounting Equation Used for?

The accounting equation is used in double-entry accounting.

It shows the relationship between your business’s assets, liabilities, and equity.

By using the accounting equation, you can see if your assets are financed by debt or business funds.

The accounting equation is also called the balance sheet equation.

Accounting Equation Formula and Calculation

Assets are basically the things which a business owns. For example, cash, inventory, property, and equipment, etc. all form part of assets.

Liabilities are basically the money which business owes to others. For example, payables, debt, etc. are a type of liabilities.

Equity is the ownership of the stakeholders in the business. So if you have started a business of your own, you are the stakeholder of the company.

The general rule of this equation is the Total assets of the company will always be equals to the sum of its Total liabilities and Total equity.

So this Accounting Equation ensures that the balance sheet remains “balanced” always and any debit entry in the system should have a corresponding credit entry.

Formula For Accounting Equation: Total Assets = Total Liabilities + Total Equity

Assets

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

Liabilities are what a company typically owes or needs to pay to keep the company running.

Debt including long-term debt are liabilities as well as rent, taxes, utilities, salaries, and wages as well as dividends payable.

Shareholders’ Equity

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.

Below are some examples of items that fall under each section:

  • Assets: Cash, Accounts Receivable, Inventory, Equipment
  • Liabilities: Accounts Payable, Short-term borrowings, Long-term Debt
  • Shareholder’s Equity: Share Capital, Retained Earnings

The accounting equation shows the relationship between these

Example

Imagine you’ve created a brand new company. On day one, as the business is hardly more than an idea, your accounting formula would look like the following:

  • Assets = Liabilities + Shareholders’ Equity
  • $0 = $0 + $0

This is a very small business, and you—the founder and owner—start it with a deposit of $1,000 into a business checking account. The accounting equation would now look like this:

  • Assets = Liabilities + Shareholders’ Equity
  • $1,000 = $0 + $1,000

Now, imagine you’ve used up your $1,000, but you still need to buy a $500 photocopier for your home office. You use a business credit card to buy the photocopier, and the accounting equation reflects this activity:

  • Assets = Liabilities + Shareholders’ Equity
  • $1,500 = $500 + $1,000

Conclusions:

As helpful as the accounting equation is in doing accounting for your business, it has its own limitations.

For starters, it doesn’t provide investors or other interested third parties with an analysis of how well the business is operating.

Additionally, it doesn’t completely prevent accounting errors from being made.

Even when the balance sheet balances itself out, there is still a possibility of error that doesn’t involve the accounting equation.

  • The accounting equations 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.

Although the balance sheet always balances out, the equation doesn’t provide investors information as to how well a company is performing.

Instead, investors must 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 is financing the company properly to ensure long term growth.

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What is the Accounting Equation, and its importance with examples
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What is the Accounting Equation, and its importance with examples
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If your small business uses the double entry accounting system, you may have heard the term “accounting equation.” What does this mean, and why does it matter to your business? Here’s a closer look at the accounting equation.
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Ganesh B Nayak

Ganesh is an Entrepreneur and a Successful Stock Market investor with 5+ years of experience in Finance Industry. Experienced in all aspects of business formation, operation, finance, and management. Ganesh help finance professionals and Fin-tech startups to build an audience and get more paying clients online.

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