The accounting equation represents the relationship between the assets, liabilities, and owner’s equity of a person or business. The accounting equation is the foundation of double-entry accounting and sets the structure of the balance sheet. In double-entry accounting, every transaction affects at least two accounts. The accounting equation shows if a company’s assets are equal to its liabilities and stockholder equity. The accounting equation is important for understanding if a company’s finances are balanced and aids accountants in making sure that the company’s balance sheet is being done in an effective and efficient manner.
The equation is set up as follows:
The accounting equation can be calculated as follows:
- Total assets should be located on the balance sheet for a particular period.
- The liabilities of a company should be listed separately in the balance sheet and calculated.
- The total liability and total stockholder’s equity should be added.
- The total liabilities and equity will equal the company’s assets.
What is the Accounting Equation?
As mentioned before, the accounting equation is a foundational equation in accounting and is used extensively in what is called double-entry bookkeeping. The accounting equation is used to show the relationship between a business’s assets, liabilities, and equity and if that relationship is balanced. The valuable resources controlled by the company are known as its assets and liabilities are the financial obligations that companies have. Both liabilities and shareholder’s equity represent how the assets of a company are financed. The accounting equation is important because it captures the relationship between the three, assets, liabilities, and equity.
How does the accounting equation work?
To understand how the accounting equation works, it is important to remember that without investments from owners or what is called ‘equity’ or without any debit borrowed from creditors or what is called ‘liabilities’, a business would have no resources or what is called ‘assets’. The amount borrowed or liabilities and the amount invested or equity plus any retained profits should always match a business’s assets.
The reason why the accounting equation always balances is in how the equation is set up. Even if the assets, liabilities, and shareholder’s equity change, a business’s total assets will always match the sum of the liabilities and equity because the equity acts as the balancing amount in the accounting equation.
The accounting equation is an expression of the relationship among a company’s assets, liabilities, and owner’s equity. The general form of the equations can be set up as:
Assets = Liabilities + Shareholder’s Equity
The left-hand side of the equation shows the resources owned by the company while the right-hand side shows the funds used to acquire those resources. The assets owned by a company are acquired with funds supplied either by creditors or by the owner. The value of assets in a business is always equal to the sum of the value of liabilities and owner’s equity. Then the total dollar amounts of the two sides of the accounting equation should always be equal because they represent two different views of the same thing.
What is the Importance of the Accounting Equation?
As mentioned before, the accounting equation is a foundational equation in accounting and is often referred to as part of a business’s balance sheet. The accounting equation is used in double-entry bookkeeping, and it ensures that a business’s accounts are balanced by maintaining that for each entry on the debit side there is a corresponding credit entry. In this way, it can depict an accurate picture of a business’s financial position for management, shareholders, potential investors, or the government.
The accounting equation provides an easy way for companies and businesses to verify the accuracy of bookkeeping. It can also measure the profitability of the company. If the liabilities are higher than the company’s assets, this may indicate that the company isn’t managing the money very well. The accounting equation is a key indicator of the financial health of a company.
What are the parts of a Balance Sheet Equation?
In order to understand how the accounting equation works, we must understand the three parts of the equations. As mentioned before, the accounting equation is part of a business’s balance sheet and is often referred to as the balance sheet equation.
Listed below are the parts of a Balance Sheet Equation.
Assets are things that a company can make money from. There are two types of assets, which are: current assets and long-term assets. Current assets are things that can be converted into money within that year and long-term assets are things that cannot be converted into money within that year. Some examples that are considered assets include:
- Cash and cash equivalents
- Building and equipment
Liabilities are things that a company owes and must pay for. These are legal obligations for businesses to pay and will increase with credit and decrease with debits. Liabilities like assets can be of two types, current which must be paid for within that year, and long-term which can be payable over a longer period of time. These are liabilities that will not be paid off during the current year. Some examples that are considered liabilities include:
- Accounts payable for goods and services
- Deferred revenue
- Taxes payable
- Salaries payable
- Interests payable
- Bonds payable
A shareholder’s equity
Shareholder’s equity is the company’s total net worth or how much the company is worth once all debts are paid. These are the accumulated profits that a company has made once all liabilities are paid off. Some examples that are considered shareholder’s equity include:
- Common stock
- Preferred stock
- Additional paid-in capital
What is the Accounting Equation Formula and Calculation?
As mentioned before, the accounting equation formula is set up as:
To see how this equation works, let’s suppose a hypothetical business with assets, liabilities, and shareholder’s equity. Any new business idea normally starts off with zero assets, liabilities, and equity.
Assets = liabilities + Shareholder’s Equity
$0 = $0 + $0
Examples of the Accounting Equation
We will consider how this accounting equation works over the course of developing a business idea into reality and the corresponding transactions. Maria wants to turn her soap-making hobby into a business. Through this example, we can see how the accounting equation can be used in establishing a new business and how the equation is applied to make sure that the business’s first year’s finances balance out.
The following transaction took place to help start Maria’s business:
- Maria deposited $1000 into her newly opened business account.
- Maria purchased $400 worth of soap-making equipment.
- Maria purchased $400 worth of raw materials for soap making that will make 1,000 bars of soap.
- Maria created a social media page and registered to pay $50 over three months for a $150 ad boosting of her product that will take place over the summer (three months).
- Maria reserved a booth at the local farmer’s market for $300 which will be paid over the course of the summer in installments of $100 each month (three months).
- During the first months at the farmer’s market, Maria sold all her products.
Calculating the accounting equation at the end of the first month of summer sales.
Cash at bank: $1000-$400-$400-$50-$100+$5000 (1,000x$5) $5050
Social Media Ad: $150-$50 ($150/3months) $100
Farmer’s Market Stand: $300 – $100 ($300/3months) $200
Farmer’s Market Stand $300
Owner’s Contribution $1000
Retained Profits $5000 (1,000x$5)-$400-$400-$50-$100 $4050
This accounting equation will balance out as shown:
$5,350 (Assets) = $300 (Liabilities) + $5050 (Equity)
We can look at real-world examples of the accounting equation if we look at a company’s balance sheet. As mentioned earlier, the accounting equation is part of a company’s balance sheet. A balance sheet lists a company’s assets, liabilities, and ownership equity at a specific date, such as at the end of its financial year. Often, balance sheets are published and available for the public to view.
For example, as of January 31st, 2022, MarketWatch.com listed Walmart Inc.’s total assets as 244.86B, total liabilities as 152.97B, and total equity as 91.89B. We can use these figures from Walmart’s January 31st, 2022 balance sheet in an accounting equation to see that the books are balanced.
244.86B (assets) = 152.97B (liabilities) + 91.89B (equity)
When adding 152.97B and 91.89B, we see that it is equal to 244.86B, the number of Walmart’s assets at that point in time.
We can do this again with a different company. Let’s look at Target Corp. this time. As of January 31st, 2022, MarketWatch listed Target Corp.’s total assets as 53.81B, total liabilities as 40.98B, and total equity as 12.83B. Again, we can plug these numbers into the accounting equation to get a good snapshot of Target Corp.’s finances.
53.81B (assets) = 40.98B (liabilities) + 12.83B (equity)
We again see that adding 40.98B and 12.83B will equal 53.81B, Target Corp’s total assets at that point in time. It is also important to note that the accounting equation can also be expressed in terms of liabilities or owner’s equity instead of assets. For example:
Liabilities = assets – owner’s equity or owner’s equity = assets – liabilities.
What are the limits of the accounting equation?
There are limits to the accounting equation. One thing that the accounting equation does not do is provide investors or other interested third parties with an analysis of how well the business is operating. It also does not completely prevent accounting errors from being made. Even if the balance sheet does balance out, there is still a possibility of an error that doesn’t involve the accounting equation.
What is the Difference between Accounting Equation and Expanded Accounting Equation?
The expanded accounting equation is related to the accounting equation in that both equations are set up the same way, however, the expanded accounting equation elaborates on the different components of the stockholder’s equity. This allows analysts to have a better understanding of how profits are being used within a company.
The expanded accounting equation would be set up as follows:
Assets= Liabilities + Contributed Capital + Beginning Retained Earning + Revenue + Expenses + Dividends.
Contributed capital is capital provided by the original stockholders. Beginning retained earnings are earnings distributed to stockholders from the previous period. Revenue is what is generated from the ongoing operation of the company. Expenses are costs incurred to run the business. Dividends are earnings distributed to the company.