In the formation of accounting data, a basic accounting equation is used for financial statements no matter if you are just a small business or a multimillion company. The Italian mathematician Luca Pacioli formulated a basic accounting equation formula in 1494 in his work “A Treatise on Accounts and Records.”
Accounting systems of all countries are based on the use of this basic accounting equation. Virtually every business transaction to be reflected in accounting can be formalized within the framework of this equation or within its several variations that we will review later in this article. So, what is the accounting equation? Let’s look at its definition from a dictionary.
What Is the Accounting Equation?
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 whereby the total of all the company’s assets equals 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.
Accounting Equation Formula
Assets = Liabilities + Owner’s Equity
Calculating the Equation
The balance sheet holds the basis of the accounting equation:
- Locate the company’s total assets on the balance sheet for the period.
- Total all liabilities, which should be a separate listing on the balance sheet.
- Locate total shareholder’s equity and add the number to total liabilities.
- Total assets will equal the sum of liabilities and total equity.
As an example, let’s say for the fiscal year, leading retailer XYZ Corporation reported the following on its balance sheet:
- Total assets: $70 Million
- Total liabilities: $20 Million
- Total shareholders’ equity: $50 Million
If we calculate the right-hand side of the accounting equation (equity + liabilities), we arrive at ($50 Million + $20 Million) = $70 Million, which matches the value of the assets reported by the company.
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 are liabilities as well as rent, taxes, utilities, salaries, and wages as well as 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.
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 items.
Rearranging the Accounting Equation
The accounting equation can also be rearranged into the following form:
Shareholder’s Equity = Assets – Liabilities
In this form, it is easier to highlight the relationship between shareholder’s equity and debt (liabilities). As you can see, shareholder’s equity is the remainder after liabilities have been subtracted from assets. This is because creditors – parties that lend money – have the first claim to a company’s assets.
For example, if a company becomes bankrupt, its assets are sold and these funds are used to settle debts first. Only after debts are settled are shareholders entitled to any of the company’s assets to attempt to recover their investments.
Regardless of how the accounting equation is represented, it is important to remember that the equation must always balance.
Why the accounting equation is important
The accounting equation can give you a clear picture of your business’s financial situation. You must calculate the accounting equation to read your balance sheet. The accounting equation helps you understand the relationship between your financial statements. In a Fundera article, Heather D. Satterley, founder of Satterley Training & Consulting, LLC, explains:
By using the accounting equations, you can see if you can fund the purchase of an asset with your business’s existing assets. And, the equation will reveal if you should pay off debts with assets (like cash) or by taking on more liabilities.
Balance Sheet and Income Statement
The balance sheet is also known as the statement of financial position and it reflects the accounting equations. The balance sheet reports a company’s assets, liabilities, and owner’s (or stockholders’) equity at a specific point in time. Like the accounting equations, 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.
Limits of the Accounting Equation
Although the balance sheet always balances out, the accounting equations don’t provide investors 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.
- 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.
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