Updated July 15, 2023
Definition of Accounting Equation
The accounting equation, also known as the founder stone of the double-entry principle of accounting entry, states that at any point during an accounting period, the total value of assets will always be equal to sum total value of the organization’s liability and owner’s fund, i.e., owner’s capital; in other words, in an accounting equation, the value of total debits should always be equal to the value of full credits.
Explanation
The accounting equation helps understand the relationship between assets, liabilities, and owner’s equity. Assets are resources owned by an organization that helps generate future economic benefits. In contrast, liabilities are financial obligations resulting in an outflow of economic resources, i.e., cash outflow or any other asset. The owner’s equity is the business’s amount to its owner, i.e., capital or reserves and surplus. It can also be described as the difference between assets and liabilities. The accounting equation forms the basis of double-entry accounting, where every transaction will affect both sides of the equation. Some common assets examples are cash, inventory, accounts receivable, equipment, etc. Liabilities include short-term borrowings, long-term debts, accounts payable, and owner’s equity, including share capital, retained earnings, etc. It may sometimes happen that certain transactions affect only one side of the equation, i.e., assets or liabilities only, like the sale of goods on credit will increase (debtors) and decrease(inventories) assets only.
The formula for Accounting Equation
- Assets = Total assets (current asset + noncurrent assets)
- Liability = Total liability (current liability + noncurrent liability)
- Owners Equity = Total shareholder’s equity (share capital + retained earnings)
Examples of Accounting Equations
Different examples mention below:
Example #1
Johnson INC. purchased a machine for $200000 and paid $100000 in cash; the rest could be paid later. The transaction results in an inflow of machines, an outflow of cash, and the creation of liability for the balance amount to be paid.
|
Assets |
Liability | Shareholder Equity |
Particular |
| $200000 | – | – | Machine Purchased |
| ($100000) | – | – | Cash Paid |
| – | $10000 | – | Liability Created |
The accounting equation calculates as
- $200000 – $100000 = $100000 + 0
- $100000 = $100000
According to the accounting equation, $100000 Assets = $100000 Liabilities
Example #2
As of 31/12/2019, Mc. Donald has total assets of $2000 Million, Liability of $1800 Million, and shareholder’s equity of $200 Million.
Solution:
Assets = Liability + Owners Equity
- $2000 = $1800 + $200
- $2000 = $2000
According to the accounting equation, $2000 Assets = $2000 Liabilities
Example #3
Show the impact of the following transactions in the accounting equation.
- Mac Purchased raw materials on the credit of $10,000
- Issued preference shares $10,000
- Took a loan from Bank for $10,000
- Paid off loan $5,000
Solution:
- The purchase of goods on credit leads to an increase in an asset by $10,000 with a simultaneous increase in liability of $10,000.
- With the issue of preference shares, it leads to an increase in preference share capital with a simultaneous rise in cash by $10,000
- With the loan proceeds, both bank balance and liability increase by $10,0000
- With the repayment of the loan, both liability and bank balance decreased by $5,000
Thus, the accounting equation is always matched in all of the above transactions, i.e., increase/ decrease occurs with the same amount.
Application of Accounting Equation
There are the varied application of accounting equations in the field of accountancy and economics: –
- Financial Statements: Annual and quarterly reports of a company are prepared with accounting books’ help using double-entry accounting practices. The entry passed in the general business ledger through equations provides data that forms the financial statement. The entry includes cash A/c, expense reports, interest and loan payments, company investments and salaries entries, etc.
- Income and Retained Earnings: It represents the income and retained earnings of the company, which is an essential component in computing, analyzing, and understanding a firm’s income statements. It means the company’s profit and loss, determined by calculating the accounting equation. It helps the business determine the revenue it earned and prepare statements of its retained earnings. Based on analyzing these earnings, future profit trends are predicted, which allows companies to make timely decisions.
- Double Entry Book-Keeping System: The accounting equation forms the foundational basis for the double-entry bookkeeping system. The double-entry system aims to keep track of each debit and credit of an organization and ensures that its sums always match up. It is based on the phenomenon that every transaction has an equal effect and is also used to transfer total entry from primary books to ledger A/c.
- Company Worth: Equation helps in evaluating the net worth of the company. It calculates company asset values; debts owned, allowing its owners to determine its assets’ total value. The book of account represents the depreciated value of an asset that would be less than its secondary market value.
- Investments: It is essential for investors to gauge the measurability of a company’s holdings and debts at any time. These frequent calculations help analyze the business’s financial position and measure its robustness.
Uses of Accounting Equation
It is used to analyze whether the assets are financed by debt or business owner funds with the help of double-entry accounting. It differentiates between business assets, liabilities, and equity. It forms a clear picture of any business’s financial situation. The accounting equation aims to determine business progress on any given day. It tells us how much money any company has in the Bank and how likely the business will meet all its financial obligations. It also helps us evaluate a business’s profit or loss since its inception. The accounting equation helps determine if the company has sufficient funds to purchase an asset if debts should be paid off with the existing assets, or by creating more liabilities.
Advantages
Some of the advantages are given below:
- It helps in assisting accounting professionals and accountants to maintain accuracy.
- The accounting equation is based on a double-entry bookkeeping system that helps balance the equation, restricting chances of error.
- It helps maintain business efficiency by determining the debits and credits of business transactions.
- It is an essential tool to classify or make reversal financial entries that help rectify the errors conveniently.
- It helps determine a business’s progress, i.e., ups or downtrends.
Disadvantages
Some of the disadvantages are given below:
- The accounting equation does not measure the events or circumstances with no monetary value. If any event, such as management, reputation, or loyalty, does not possess money value, it has no place in the accounting equation.
- The accounting equation uses predetermined cost to evaluate values that ignore the factors such as inflation, price change, etc., and thus lose the relevancy of accounting information.
- As humans make up the accounting equation, there remains a scope of error and deliberate fraud that is harder to spot.
Conclusion
The accounting equation depicts the company’s valuable resources representing their obligations in the form of liabilities. It thus helps shareholders determine the company’s worth and establish the relationship between them. However, it may not give investors the proper knowledge of the company’s future, which may hinder further investment. It also provides insights into the growing trend, which can help stakeholders make sound business and economic decisions.
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