Accounting Equation Formula (Table of Contents)
- Accounting Equation Formula
- How to Calculate the Accounting Equation?
- Examples of Accounting Equation Formula
Accounting Equation Formula
Anyone who is studying accounting or have already studied, they start their basic from the accounting equation. The reason for this is that this is the accounting equation formula which is the basic foundation of the double-entry accounting system. It is also known as an Accounting Equation balance sheet since it tells us the relation between balance sheet items i.e. Assets, Liabilities, and Equity.
Assets are basically the things which a business owns. For example, cash, inventory, property, and equipment, etc. all form part of assets.
Liabilities are basically the money which business owes to others. For example, payables, debt, etc. are a type of liabilities.
Equity is the ownership of the stakeholders in the business. So if you have started a business of your own, you are the stakeholder of the company.
The general rule of this equation is the Total assets of the company will always be equals to the sum of its Total liabilities and Total equity. So this Accounting Equation ensures that the balance sheet remains “balanced” always and any debit entry in the system should have a corresponding credit entry.
Formula For Accounting Equation:
We can re-write it as:
And
How to Calculate the Accounting Equation?
Following are the steps which need to be followed to calculate the accounting equation
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- Before finding the equation, keep in mind that left side of the balance sheet is the assets side and also known as “Debit side” and the right side is Liability and equity side also called “Credit side”.
- On the company balance sheet, find all the assets (current and non-current) for the period for which we are determining the equation.
- Similarly, find total liabilities (current and non-current) and shareholder’s equity for that period and add these two numbers.
- Total assets should be equal to the sum of liabilities and total equity.
- Using an accounting equation formula, we can find out the value of any of the missing variable value if we have other two.
Examples of Accounting Equation Formula
Let’s take an example to understand the calculation of the Accounting Equation formula in a better manner.
Accounting Equation Formula – Example #1
Suppose you have just started a new of selling cupcakes. Now, you invested $10,000 from your pocket. So that will be your equity investment and will become an asset for the company.
So equation:
- Total Assets = Total Liabilities + Total Equity
- $10,000 = 0 + $10,000
So it is balanced.
Now say after 2 years, you want to expand the business but do not have funds. So you go to a bank and get a loan of another $10,000 to expand the operations. This will increase your assets and also increase your liabilities.
So
- Total Assets = Total Liabilities + Total Equity
- $10,000 + $10,000 = $10,000 + $10,000
- $20,000 = $10,000 + $10,000
- $20,000 = $20,000
Again it is balanced.
Now you have expanded your business, you have suppliers of raw materials. You are not paying in cash but paying them after some time. So that will the payables which you have to say $4000. This will increase your assets and liability as well.
So
- Total Assets = Total Liabilities + Total Equity
- $20,000 + $4,000 = $10,000 + $4,000 + $10,000
- $24,000 = $24,000
Again it is balanced.
So we can see that every scenario, the left side of the equation is the same as the right, so it is balanced. That is the whole point of the equation.
Accounting Equation Formula – Example #2
Now let see a practical example from the industry and see if the accounting equation holds true or not. I have considered TATA MOTORS as an example. Below is the snapshot of Tata Motor’s Balance sheet:
Liabilities and Shareholders’ Equity
Assets
Source Link: TATA MOTORS Balance Sheet
If you see here, Total assets for the period ending Mar’18 is 331,350.51 Crores and for Mar’17 is 273,754.36 Crores. Same is the value for the sum of Liabilities and shareholder’s equity.
Explanation
As discussed above, assets should be the same as the sum of liabilities and shareholder’s equity. But we can also expand this Accounting Equation formula to have a better understanding and see how income statement items are affecting the balance sheet. The expanded Accounting Equation formula gives us the relation between the income statement and balance sheet. The expanded equation is given as:
Assets = Liabilities + Shareholder’s Equity + Revenue – Expenses – Draws
Revenues are basically sales which the business will do and expenses are the cost which business will incur to achieve those revenues. Generally:
- Revenue increases owner’s equity.
- Expenses decrease owner’s equity.
- Owner’s draw decreases owner’s equity.
The two sides of the equation must equal each other. If the expanded accounting equation formula is not balanced, your financial reports are inaccurate.
Relevance and Uses of Accounting Equation Formula
It can help us to see a clear picture of a business’s financial situation. Not only that, but the Accounting Equation will also help us to understand the relation between the elements of financial statements i.e income statement and balance sheet. If we want to explain the importance of the accounting equation, we can say that it is the foundation of the double-entry accounting system. This system ensures that the equation always remains balanced which essentially means that assets should always be equal to the sum of liabilities and shareholder’s equity. In a Fundera article, Heather D. Satterley, founder of Satterley Training & Consulting, LLC, explains:
“The purpose of the balance sheet is to show the financial position of the business on any given day. The balance sheet can tell you how much money the business has in the bank and how likely it is that the business will be able to meet all of its financial obligations. It can also tell you how much profit (or loss) the business has retained since it started”
All the companies across the globe adhere to the double-entry accounting system which makes accounting more standardized and much easier to tally.
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