The word ‘equation’ gives a feeling of anxiety or maybe a cringe for two kinds of people in the world: those who don’t love Math and those who aren’t loved by Math either.
So, the term, accounting equation sounds scary if you hear it for the first time. “It’s all Greek to me,” you might say. But truth be told, accounting equation can be as easy as one, two, three. Let’s find out why.
LIABILITIES. OWNER’S EQUITY. ASSETS.
These three accounting terms are the key elements that comprise the basic accounting equation. Assets are equal to liabilities plus owner’s equity (A = L + OE).
In crystal-clear terms, accrual means the accumulation or increase of something over time, especially payments or benefits. In accounting principles, accrual refers to earned revenues and incurred expenses that significantly impact an income statement of a business over a period.
To simplify, let us use the numbers 1, 2, and 3. Then, let us assign these values to the three elements; liabilities for 1, Owner’s equity as 2 and Assets for 3.
If 1+2 =3, then, it follows that liabilities + owner’s equity = assets.
Easy as 1, 2, 3, right? You want another way to solve it? Easy!
3 – 1 = 2
(Assets – Liabilities = Owner’s Equity)
There you have it, easy as 1, 2, 3!
Accounting Equation Calculation
The balance sheet is the key to calculate the basic accounting equation. If you now hold a balance sheet, look for the following:
A. the total amount of assets
B. the total amount of liabilities
C. the total amount of shareholder’s equity or the owner’s equity
After identifying key figures, D. add the total amount of liabilities to total amount of owner’s equity
E. compare the total amount of assets to the total amount of equity and liabilities combined
To apply these concepts, let us look at this example:
Company X released their updated balance sheet which holds the following figures
Total Assets = $10 million
Liabilities = $5 million
Owner’s equity = $5 million
To check the balance, we need to get the sum of the number of liabilities and owner’s equity. As given, both are worth $5 million; so, $5 million (worth of liabilities) + $5 million (worth of owner’s equity) is equal to $10 million.
Now, compare the sum of the two to the total amount of assets. It follows that total assets ($10 million) = total liabilities and owner’s equity ($10 million)
Company X was able to reflect an accurate accounting equation calculation as its total amount of assets (left side of the equation) matches or the total amount of liabilities and owner’s equity (right side of the equation) as reported.
It doesn’t take a genius to memorize or understand the formula. But now that the equation formula is solved let us look at the concepts or the three elements that make up the accounting equation.
Parsing the Accounting Equation
A company’s financial health can be gauged through an analysis of the two main components of the balance sheet – assets and liabilities. Assets and liabilities usually come as a package. Buy one, take one. You increase one, and you decrease the other and vice versa. They are always inseparable when recording transactions.
Assets reflect the company’s acquired and saved resources, while liabilities refer to the financial obligations of the company. Liabilities and owner’s equity give us the idea of how the assets are financed. The value of the owner’s equity shows us how much the company depends on its shareholders to earn working capital while the amount of liabilities shows us that they are being financed through banks or other financial institutions.
Using the fundamental accounting equation, the balance sheet enumerates all its financial accounts be it credit or debit.
Let us scrutinize what accounts are enlisted under each element of the equation:
Assets – everything the company owns: cash, stock, advance payments, (and profits in other forms), savings account, receivables, inventory of items and equipment, intangibles (goodwill, patents, copyrights, and trademarks).
Liabilities – everything the company owes: debts, mortgages and rentals, taxes, operational costs, payables, other bills.
Owner’s Equity – the difference between assets and liabilities; the amount of money belonging to the owner of the company and retained earnings.
Double-entry accounting system accounts for the recording of business transactions in a minimum of two accounts. In essence, debits should be equal to credits when recording all transactions.
Regarded as the foundation of the double-entry accounting system, the accounting equation is usually found on the balance sheet of a company’s financial statements in which the formula, assets equals liabilities plus owner’s equity, is at work.
The double-entry system adheres to the rules of debit and credit entries. As a result, debit and credit must always be of the same value when recording a transaction using the double-entry system. Thus, the balance sheet shows a balance through the accounting equation.
Balance Sheet in a relationship with Income Statement
To understand the balance sheet and how it works, you need to figure that the accounting equation serves as the core component of the accounting system.
A pivotal financial statement, such as the balance sheet becomes more comfortable to analyze if and when the accounting equation is set into balance. A balance sheet is commonly prepared to show the financial balance of the business at one point in time.
An income statement, meanwhile, gives us a clear picture of a company’s flow of cash, revenues, or net income and expenses over some time. At the very least, an income statement may serve as a reference for the changes in the owner’s equity amount given two balance sheets in perusal.
Accounting Equation’s Parameters and Unknowns
The accounting equation gives the balance sheet the sense of balance it ought to show. However, the accounting equation doesn’t show a more unobstructed view of the company’s financial performance over the years. Investors must keep an eye to each part or critical element of the accounting equation and get a good understanding of the figures and its implications.
Significant rise and fall, or even large discrepancies of values in assets, liabilities, and owner’s equity might be indications of the real wealth of the company that should be insignificant consideration before deciding to invest.
Out of equation
After probing and solving the accounting equation, we now go to the conclusion of its essence.
Primarily, the accounting equation helps us see the relationship of financial transactions of a company; learn how they earn and how they spend. As the relationship between liability and asset is created through the accounting equation, the accounting process gets more comfortable.
The basic accounting equation shows that the total assets of a company will eternally be equated to the combined values of owners’ money and funds coming from lenders. The accounting equation is the basis for an accurate recording of business transactions to aid companies with their financial management.