The Importance of Accounting Equation
The accounting equation is the basic accounting equation, representing the relationship among the liabilities, assets, and owner’s equity of a business. It is the foundation of double entry principle in accounting system. Double entry principle indicates that the total debits are equal to the total credits for any transaction. Incorporate with that principle, the equation displays that all assets of an entity are either financed by browning or the company’s shareholders. It is also known balance sheet equation.
The mathematical expression of the accounting equation is: Assets = Liabilities + Owner’s Equity or A==L+E. It is most commonly used to balance sheet, the final financial statement for a company. It is the systematic form of representing company status, displaying the total assets of a company is equal to the total liabilities and shareholder equity. The balance sheet is a complex expression of this equation, presenting the total assets of a company is equal to the total of liabilities and owner’s equity. According to double entry principle, every transaction of an entity has an equal result on both sides of the equation. From this equation, the formula may also be rearranged to determine one of the other unknown issues like liabilities or owners’ equity. Such as, it can be also written as Liabilities = Assets – Owners Equity, to determine liabilities and Owners Equity = Assets – Liabilities, to find out Owners’ equity.
Components of Accounting Equations
From above discussions we know, there are three core components of accounting equation. Those are assets, liabilities and owner’s equity.
Assets are economic resources that have value or can create value. It can be considered as tangible or intangible wealth that is capable of being productive and also have positive economic value. In a simple word, assets represent the value of ownership that can be easily converted into cash. Though, cash is also considered as a special form of assets. In accounting context, assets are found in two forms. Assets that can consume within one year are considered as current assets. It includes things like inventory, accounts receivable and mostly common, cash. Fixed assets are expected to earn revenue or have utilized more than one year. It includes furniture, equipment, real estate and buildings.
Liabilities are defined as a responsibility or commitment of an entity, triggering from past business events or transactions. It can be the result of transferring assets, provision of services or interests from various investments. It can be also defined as, company’s legal amount outstanding or responsibilities that arise from the business operations. These are settled over time by the transfer of monetary benefits with goods, services or money. Liabilities are a very important feature of a company’s action procedure because they are used to finance regular operations and also needed to expand the business.
The term equity is the residual claimant or the interest of the investors in business when all liabilities are paid. When a business started, the owners put the initial funding into the business to operate financial operations. This funding creates a liability on the business in the shape of capital because according to the accounting principles, business is considered as a separate entity from its owners. In the accounting contexts, business is considered as purposes with the liabilities and assets. After calculating all liabilities, remain assets of a business is considered as the owner’s equity.
The Basic Accounting Formula
The formula basically shows the assets of the firm that are purchased by either its liabilities or by its owner’s investments. The total relationship among these components is expressed in the form of an equation: Assets = Liabilities + Owner’s Capital Examples are assets are items like inventory or machineries and examples of liabilities are accounts payable or bank loans. Owner’s equity or owner’s capital is the investment by the owner in the firm. From the basic equation, some other determinant formula can be formulated: Liabilities = Assets – Owner’s Equity Owner’s Equity = Assets – Liabilities So, you need to know any two components to calculate third one.
The Expansion of Accounting Formula
The basic calculation is all about the three components – assets, liabilities and owner’s equity. It can be expanded and the expanded equation shows the relationship between the balance sheet and the income statement. The Owner’s Equity can be broken into two parts; revenue and expenses. So far, we only discussed about the balance sheet part of the equation. Now, if we divide the owner’s equity revenue and expenses then income statement will also add in the equation. Revenue generated from sales and the relation between expenses and revenue is when the revenue is greater than expenses, the company will earn profit. On the other hand, if the expenses are greater than revenue, the company will face losing money. After considering the sales and revenue, the expanded accounting equation will be: Assets = Liabilities + Owner’s Equity + Revenue – Expenses – Draws
Applications of Accounting Equation
The accounting equation is the basic accounting equation, representing the relationship among the liabilities, assets, and owner’s equity of a business. It is the foundation of double entry principle in accounting system. It is applicable on the following accounting statements and systems:
Accounting equation is used to prepare financial statement named balance sheet. It is an annual report sometime prepare quarterly and derived directly from the accounting equations used in bookkeeping practices.
Double Entry Bookkeeping System
This equation plays an important part in the foundation of the double entry bookkeeping system. It makes sure that a company’s accounts are always balanced.
Income and Retained Earnings
It is used to calculate income and retained earnings. This equation is also an essential module in understanding, computing, and analyzing a firm’s income statement. In other words, it allows an entity to determine revenue and retained earnings.
It shows how much the company holds and its total debits. By preparing the balance sheet according to accounting equation allows owners to gauge the total value of a business. Investments It has a role in determining a company’s net worth. In this process it provides valuable information to investors to consider a loan application or investment in the company. In the bottom line, it is important to maintain statement according to accounting equations. Otherwise, your financial reports will not make any sense. You cannot able to keep track of your financial transactions also.