The chief financial goal of the business is to maximize profits, which leads to an improvement in the well-being of the owners of the company. The financial position of the business unit depends on the availability and structure of economic resources. These resources (assets) and where they came from can be represented in a simple equation that is used mainly to form a balance sheet – Assets = Liabilities + Owner’s Equity, where
⮚ Assets are resources controlled by an enterprise as a result of past events, from which the company expects economic benefits in the future. According to international accounting standards, all assets are classified as short-term and long-term. Assets can be one of the following:
- something belonging to you – money, land, buildings, goods, trademarks, shares of other companies, equipment, transport;
- something that others owe you – something yours, but temporarily in possession of someone else. Most often, it is money (receivables).
⮚ Liabilities are everything that you owe to others and are obliged to return within a specified period. This is the debt of the enterprise arising from the events of
previous periods, the settlement of which will lead to an outflow of resources from the enterprise containing economic benefits.⮚ Equity is a part of the assets of an enterprise that remains after deducting all its liabilities, i.e., investment is the share of ownership of the owner in the company. Equity includes equity (contributed) capital and retained earnings.
The Extended Accounting Equation
The basic version of the accounting equation is not the only way the accounting equation may be expressed as. So, what is the accounting equation? The basic accounting equation reflects the relationship of assets, liabilities, equity at a certain point in time. However, if revenues and expenses are added to this formula at the beginning and the end of the reporting period, then a form of equality that reflects the interrelation of the necessary reporting elements at a particular moment will be obtained.
We begin with:
Assets = Liabilities + Owner’s Equity
We bring in the profit element:
Assets = Liabilities + Owner’s Equity + Profit
Note: Profit = Revenue – Expenses
The accounting equation may be expressed as:
Assets = Liabilities + Owner’s Equity + Revenue – Expenses
This type of accounting equation reflects the relationship between the balance sheet and the income statement. The result of the income statement is the net profit, which is the difference between revenues and expenses for the reporting period and is the main reason for the change in equity.
The amount of equity during the reporting period may change not only at the expense of revenues and costs but also at the expense of investments and dividends, as well as the payment of revenues and expenses directly attributable to owner’s equity (for example, revaluation of fixed assets).
Accounting equation and balance
Everything in business as in life should be balanced, and this balance in the market is achieved with the help of a basic accounting equation. Even if you are not an accountant and a finance expert, you probably heard about the balance sheet as an element that everyone is talking about and which everyone attaches the highest importance.
What does the balance represented in the balance sheet mean in terms of business? It shows the company’s assets and the sources of their formation. That is why the sum of assets is always equal to the sum of the sources of their structure, that is, liabilities and owner’s equity. So, the accounting equation may be expressed as.
Assets = Liabilities + Owner’s equity
This equation is also known as the balanced equation. Both parts must be equal to each other. After all, nothing comes from nowhere or disappears. Balance reflects the financial position of the company at a certain date, for example, at the end of the reporting period. Balance characterizes an enterprise as a holder of assets that are equal to their sources – liabilities, and equity.
Accounting Equation Role in Double-Entry Method
Double entry is a bookkeeping method in which each change in the status of an organization’s funds is reflected in at least two accounts, ensuring an overall balance. Double entry in accounting – is one of the main elements of the formation of reliable information on the economic operations of the enterprise. The method of double-entry in accounting means a timely and accurate reflection of transactions in the accounts.
The double record of business transactions allows you to maintain a balance and identify errors in the account. This method means that all business transactions are reflected in the interrelated accounts, and it provides an interconnection between accounts. The connection between accounts is called correspondence of accounts, and the accounts themselves are called corresponding. The results of proper maintenance are:
- creation of a unified accounting system;
- control over the use of available resources and sources of funding;
- proper reporting.
The essence of the double-entry method is to reflect any transaction in accounting at the same time on debit and credit accounts. Thus, the ability to immediately see the path of receipt and outflow of funds gives many advantages to specialists seeking to improve the economic condition of the company. Note that the simultaneous reflection of operations on debit and credit of accounts ensures the equality of the balance of debit and credit of all involved accounts of the organization at the reporting date in the balance sheet. Therefore, it guarantees the balance reflected in the equation as Assets= Liabilities + Owner’s Equity.
The double entry shows the ways of receipt and disposal of individual funds, the types of operations that made changes to these funds, the sources of their formation, as well as the financial results that characterize the production activity.
The accounting equation in action
Above, you can see business transactions entered into an accounting equation. In the beginning, the owner invested $10,000 into the business, which increased assets and the owner’s equity. Then, he withdrew $100 for his personal needs, which decreased the number of company assets and the owner’s equity. Next, he purchased equipment for the company with cash for $5,000, which increased one asset account (Equipment)and decreased another (Cash). After totaling the numbers, you can see that the equation is balanced, which means that all transactions were entered correctly.