The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a person or business. It is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as furthermore:
- ^{[1]}^{[2]}
- ^{[1]}^{[3]}
In a corporation, capital represents the stockholders' equity. Since every business transaction affects at least two of a company's accounts, the accounting equation will always be "in balance", meaning the left side of its balance sheet should always equal the right side. Thus, the accounting formula essentially shows that what the firm owns (its assets) is purchased by either what it owes (its liabilities) or by what its owners invest (its shareholders' equity or capital); note that the profits earned by the company, is ultimately owned by its owners.
The formula can be rewritten:
- Assets - Liabilities = (Shareholders' or Owners' Equity)^{[1]}
Now it shows owners' equity is equal to property (assets) minus debts (liabilities). Since in a corporation owners are shareholders, owner's equity is called shareholders' equity. Every accounting transaction affects at least one element of the equation, but always balances. Simple transactions also include:^{[4]}
Transaction Number |
Assets | Liabilities | Equity | Explanation | |||
---|---|---|---|---|---|---|---|
1 | + | 6,000 | + | 6,000 | Issuing stocks for cash or other assets | ||
2 | + | 10,000 | + | 10,000 | Buying assets by borrowing money (taking a loan from a bank or simply buying on credit) | ||
3 | − | 900 | − | 900 | Selling assets for cash to pay off liabilities: both assets and liabilities are reduced | ||
4 | + | 1,000 | + | 400 | + | 600 | Buying assets by paying cash by shareholder's money (600) and by borrowing money (400) |
5 | + | 700 | + | 700 | Earning revenues | ||
6 | − | 200 | − | 200 | Paying expenses (e.g. rent or professional fees) or dividends | ||
7 | + | 100 | − | 100 | Recording expenses, but not paying them at the moment | ||
8 | − | 500 | − | 500 | Paying a debt that you owe | ||
9 | 0 | 0 | 0 | Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities |
These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.
This equation is part of the transaction analysis model,^{[5]} for which we also write
- Owner's equity = Contributed Capital + Retained Earnings
- Retained Earnings = Net Income − Dividends
and
- Net Income = Income − Expenses
The equation resulting from making these substitutions in the accounting equation may be referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation.^{[6]}
- Assets = Liabilities + Contributed Capital + Revenue - Expenses - Dividends
Applications
The accounting equation is fundamental to the double-entry bookkeeping practice. Its applications in accountancy and economics are thus diverse.
Financial statement
A company's quarterly and annual reports are basically derived directly from the accounting equations used in bookkeeping practices. These equations, entered in a business's general ledger, will provide the material that eventually makes up the foundation of a business's financial statements. This includes expense reports, cash flow, interest and loan payments, salaries, and company investments.
Double entry bookkeeping system
The accounting equation plays a significant role as the foundation of the double-entry bookkeeping system. The primary aim of the double-entry system is to keep track of debits and credits and ensure that the sum of these always matches up to the company assets, a calculation carried out by the accounting equation. It is based on the idea that each transaction has an equal effect. It is used to transfer totals from books of prime entry into the nominal ledger. Every transaction is recorded twice so that the debit is balanced by a credit.
Income and retained earnings
The income and retained earnings of the accounting equation is also an essential component in computing, understanding, and analyzing a firm's income statement. This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly. Thus, the accounting equation is an essential step in determining company profitability.
Company worth
Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm's assets.
However, due to the fact that accounting is kept on a historical basis, the equity is typically not the net worth of the organization. Often, a company may depreciate capital assets in 5–7 years, meaning that the assets will show on the books as less than their "real" value, or what they would be worth on the secondary market.
Investments
Due to its role in determining a firm's net worth, the accounting equation is an important tool for investors looking to measure a company's holdings and debts at any particular time, and frequent calculations can indicate how steady or erratic a business's financial dealings might be. This provides valuable information to creditors or banks that might be considering a loan application or investment in the company.^{[7]}
References
Library resources about Accounting equation |
- ^ ^{a} ^{b} ^{c} Meigs and Meigs. Financial Accounting, Fourth Edition. McGraw-Hill, 1983. pp.19-20.
- ^ Financial Accounting 5th Ed,p 47, HornGren, Harrison, Bamber, Best, Fraser, Willet, Pearson/Prenticehall, 2006
- ^ Financial Accounting 5th Ed,p 47, HornGren, Harrison, Bamber, Best, Fraser, Willet, Pearson/Prenticehall, 2006
- ^ Accounting equation explanation with examples, accountingcoach.com.
- ^ Libby, Libby, and Short. Financial Accounting, Third Edition. McGraw-Hill, 2001. p.120
- ^ Wild.Financial Accounting, Third Edition.McGraw-Hill, 2005. p.13, ISBN 978-0078025389
- ^ "Accounting Equation". Archived from the original on 14 May 2013. Retrieved 30 April 2013.