Definition of Accounting Equation
The accounting equation is 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 total credits.
The accounting equation helps in understanding the relationship between the assets, liabilities, and owner’s equity. Assets are resources owned by an organization that helps generate future economic benefits whereas liabilities are financial obligation which will result 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 the 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 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 Equation
Following are the examples are given below:
Johnson INC. purchased a machine for $200000 and pays $100000 in cash, and the rest amount was allowed to be paid later. The transaction results in an inflow of machine and outflow of cash and the creation of liability for the balance amount to be paid.
Accounting Equation is calculated as
Assets = Liability + Owners Equity
- $200000 – $100000 = $100000 + 0
- $100000 = $100000
According to the accounting equation $100000 Assets = $100000 Liabilities
As of 31/12/2019, Mc. Donaldhaving total assets of $2000 Million, Liability of $1800 Million and shareholder’s equity of $200 Million.
Assets = Liability + Owners Equity
- $2000 = $1800 + $200
- $2000 = $2000
According to the accounting equation $2000 Assets = $2000 Liabilities
Show the impact of the following transactions in the accounting equation.
- Mac Purchased raw material on credit $10,000
- Issued preference shares $10,000
- Took a loan from Bank $10,000
- Paid of loan $5,000
- 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 increase 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, in all of the above transactions, the accounting equation is always matched, i.e. increase/ decrease takes place with the same amount.
Application of Accounting Equation
There are the varied application of accounting equation 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 business general 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 firms income statements. It represents the company’s profit and loss that is determined by the calculation of the accounting equation. It helps the business in determining the revenue it earned and prepare statements of its retained earnings. On the basis of analyzing these earnings, the future profit trends are predicted, which helps business 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 credits of an organization and ensures that its sums always match up. It is based on the phenomena 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 assets values; debts owned and further allows its owners to determine its assets’ total value. The book of account represents the depreciated value of an asset which would be less than their secondary market value.
- Investments: It is an important tool for investors to gauge the measurability of a company’s holdings and debts at any point of time. These frequent calculations help in analyzing the financial position of the business and give a measure of 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 financial situation. The purpose of the accounting equation is to determine business progress on any given day. It tells us how much money any business has in the bank and how likely it is for the business to meet all its financial obligations. It also helps us in evaluating the amount of profit or loss that a business has incurred since its inception. The accounting equation helps determine if the business has sufficient funds to purchase an asset or debts should be paid off with the existing assets or by creating more liabilities.
Some of the advantages are given below:
- The accounting equation helps in assisting the accounting professionals and accountants to maintain accuracy.
- The accounting equation is based on a double-entry bookkeeping system that helps in balancing the equation, restricting chances of error.
- It helps in maintaining business efficiency by determining the debits and credits of business transactions.
- It serves as an important tool to classify or make reversal financial entries that helps in rectifying the errors conveniently.
- It helps in determining the progress, i.e. ups or downtrends, of a business.
Some of the disadvantages are given below:
- The accounting equation does not measure the events or circumstances that do not have a monetary value. If any event such as management, reputation, 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 loses the relevancy of accounting information.
- As humans make up the accounting equation, there always remains a scope of error and deliberate fraud that is harder to spot.
The accounting equation depicts the company’s valuable resources representing their obligations in the form of liabilities and thus helps shareholders determine the worth of the company and establish the relationship between them. However, it may not provide investors with the proper knowledge of the company’s future, which may hinder further investment but still provides insights about the growth trend, which can help stakeholders make sound business and economic decisions.
This is a guide to Accounting Equation. Here we also discuss the definition and application of the accounting equation along with its advantages and disadvantages. You may also have a look at the following articles to learn more –