Accounting Equation

What Is the Accounting Equation?

The accounting equation is a mathematical model that describes the relationship of financial activities within a business. Accountants and finance professionals use it to organize and analyze data related to companies.

The accounting equation is considered the fundamental principle of double-entry accounting. A corporate balance sheet shows exactly where a company’s assets came from and tells where they are going.

In simple terms, an accounting equation is a line that represents the total amount of money owed by the company on any one item or service; this can include unpaid bills, unpaid taxes, or uncollected fines.

Understanding the Accounting Equation

The accounting equation is a framework used by financial institutions to calculate the liability (liability = revenue/expenses) between different organization divisions. It provides a method for recording transactions between business units and may be based on custom or general accounting principles.

 Accounting Equation generally includes three main elements: Balance Sheet, Cash Flowsheet, and Income statement.

When you’re looking at a company’s financial statements, assets are resources that still belong to the company — everyday items such as cash, buildings, vehicles, and machinery. For example, if you own a business and have a shop front, the building is an asset. Liabilities are what the company owes — for example, money owed on credit cards or outstanding loans and invoices. Equity is how much it would cost to buy out all of the shareholders. Shares represent a part of ownership.

The accounting equation shows the link between the assets of a company and its liabilities and its owners’ capital.

All companies that file their accounts must use some form of this equation to calculate the relevant data. The basic idea behind the accounting equation is that it is a simplified breakdown of the values entered into the balance sheet by the company’s management.

Assets

Assets include cash and cash equivalents, accounts receivable, amounts owed by customers to the company to sell its product and service, and inventory.

Liabilities

A liability is something you owe, or that needs to be paid. For example, debt, rent, utilities, salaries, wages, and dividends are liabilities.

Shareholders’ Equity

Shareholders’ equity represents the value that would remain after all of a company’s assets have been sold and its liabilities have been paid off. Shareholders’ equity is a company’s net worth, which is the difference between its total assets and total liabilities.

Retained earnings are the result of savings. They are equal to the sum of total earnings that were not paid to shareholders as dividends. Retained earnings are one of two parts that make up shareholder equity.

The Double-Entry System

The double-entry system is used for keeping track of financial information, including cash, credit cards, receivables, inventory, assets/liabilities, and projects (included in the elements of a business). A double-entry system is made up of two books, each with its own set of entries. The book corresponding to the incoming data entry is called the book containing the incoming data (internally referred to as cash). The other book contains notes about previous entries (internally referred to as Accounts Receivable).

A double-entry system is used in accounting because 

1.) It is easy to understand and improves the overall handling of financial data. 

2.) It enhances the security of the financial records by ensuring that only authorized persons have access to the information in any given accounting period.

 3.) It facilitates the reconciliation of information when discrepancies occur: If income from one source changes while another is being subtracted from the overall balance sheet, for example, a single incorrect entry in one place could be easily accommodated by re-entering the correct information in another place.

The double-entry system stands as a cornerstone of how a business is organized. Not only is it fast, easy, and efficient, but it also allows shareholders and employees to see every transaction happening on their behalf. It is used in every aspect of accounting, including maintaining financial records for assets, liabilities, revenue, and expenses. The idea behind double-entry accounting is that each transaction should be recorded two times: once at the origin and once at the end. This improves the accuracy of data recording, as well as the ease of auditing activities.

Limits of the Accounting Equation

Despite the balance sheet always balancing out, the accounting equation fails to provide investors with sufficient information about how well a company performs financially. When evaluating a company, investors must be aware of the ratio between all of the company’s different assets and expenses, determine whether the company’s current assets can cover inconvenient expenses, and ensure the company is making progress toward long-term financial goals.

Real-World Example

As of December 31, 2016, Tesla Motors has cash assets of $362,597 and total liabilities of $163,659. The company’s shareholders have equity of $198,938.

As per the accounting equation formula 

Assets = liabilities + shareholders’ equity is calculated as follows:

$362,597= $163,659+ $198,938.

Accounting Equation Formula and calculation

Assets = (Liabilities + Owner’s Equity)

Assets are the real things we own. 

Liabilities are what we owe to others or things outside our control, like a car that won’t start or a computer that won’t work.

Owner’s equity is what we own minus our liabilities plus the equity in our REIT, if any.

Accounting equation is a simple formula used by many companies to calculate the balance sheet data. The equation is used to compare how much money each category of assets has on a specific day. It also compares each asset or liability with its respective owner’s equity. When you calculate the balance sheet correctly, you will have more accurate knowledge about your company and its financial health.

Why is the accounting equation important?

All companies have expenses that they have to pay to their suppliers and that suppliers have to pay to their clients. All companies have liabilities and equity; those figures are sometimes known as balances. The accounting equation shows us what each of these groups of accounts owes, and it shows us how much each of them can afford to pay in any given situation.

The accounting equation is a simple way to view your liabilities and your assets. Your liabilities are absorbed by what you earn or generate; your assets are reflected in the assets column of your statements, and they increase or decrease depending on whether you have earned money or not. The accounting equation is a useful way to think about finance, and it shows how much debt or equity (negative or positive) you have at any given time.

What is an example of the accounting equation?

The accounting equation used to determine taxes owed is a fundamental part of nearly every financial equation. It shows how income and expenses match up for an individual or business in a given period. For instance, if you make $100,000 in income and spend $90,000 on expenses, then you have $10,000 worth of income that owes taxes and another $10,000 worth that is free of taxes. To avoid paying more in taxes than you owe, you need to either reduce your expenses or increase your income.