Basic Accounting Equation
Does your business use the double-entry accounting system? If so, you’ve likely come across people talking about the accounting equation. Perhaps you’re asking yourself, “what is the accounting equation?” Please keep reading to learn more about the fundamental accounting equation and why it matters for you and your business.
What is the Accounting Equation?
Also known as the basic accounting equation, this equation forms the foundation of double-entry based accounting. Double-entry accounting is when every financial transaction is entered into two places in the accounts. Transactions are recorded as credit and debit under this system. While small businesses and sole traders can get away with single-entry accounting, double-entry accounting helps with error checking. Some companies have to use double-entry accounting under rules put forth by the IRS.
The accounting equation is a fundamental part of the balance sheet and one of accounting’s basic principles. The equation itself is easy to understand. It is;
Assets = Liabilities + Shareholder’s Equity
The equation forms the foundation of double-entry accounting. This fundamental accounting equation highlights the structure of your balance sheet. Double-entry accounting affects both ends of the accounting equation because of how you record transactions twice. Every change to the asset account causes an equal change to the liability/equity account. It helps to keep the equation in mind when entering journal entries into your books or accounting software.
Your business balance sheet is divided into three major sections and the underlying items for those sections. There’s the Assets section, Liabilities section, and Shareholder’s Equity section. Both sides of the equation have an equal net effect with every transaction recorded.
We’ll get to some examples of the equation in action later. For now, let’s break down each aspect of the equation.
Assets refer to any resource owned or controlled by the company and used for the company’s benefit. Some assets are tangible things such as cash, and others are intangible assets such as copyrights and business goodwill.
Accounts receivable are another common form of assets. Receivables are promises that one party will pay another. Receivables happen when companies provide services and products to people on credit under the assumption the money will eventually change hands.
Here are some common assets most businesses have;
- Prepaid expenses
- Accounts receivable
Liabilities refer to how much money companies owe to other people or organizations. Liabilities are the creditor claims on company assets. It refers to how much assets a creditor would own if something happened and the company was liquidated.
Payables are the most common liabilities for companies to have. Payables are the opposite of receivables. Payables are recorded in the books when a company purchases goods and services from another company or entity. The liability indicates one business will pay the other.
Here are some common liabilities businesses have;
- Bank loans
- Personal loans
- Lines of credit
- Accounts payable
- Officer Loans
- Unearned income
Equity refers to the proportion of company assets owned by partners and shareholders. The shareholders have the assets left over after all liabilities are paid off, which forms equity.
Owners can improve their ownership stake in a company by contributing to the company and enhancing equity. They can also reduce their share by taking money out of the company and reducing equity. Similarly, revenues boost equity, while expenses eliminate equity.
The following are common forms of equity;
- Owner capital
- Owner withdrawals
- Unearned income
- Common stock
- Officer loans
- Paid-in capital
What is the Accounting Equation Used For?
As you can tell, the basic accounting equation is an integral part of double-entry accounting. The equation helps to ensure businesses record their credit and debit appropriately. Outside of this, the equation also helps measure the profitability of a business.
The fundamental accounting equation is the foundation of a balance sheet detailing assets, liabilities, and equity.
The accounting equation helps with business financing for companies. The equation gives investors and lenders an idea of the financial situation of your business. What kind of liabilities and assets do you have? Lenders need to know this to see how well you manage money and if they can trust you with more.
Accounting Equation Examples
Let’s look at some examples of the equation in action.
- Buying a new machine with company cash
Company A wants to spend $500 in cash to purchase a new machine. The transaction causes a debit of +$500 for Equipment and credit of -$500 to Cash. Let’s put this information into the equation and see what happens;
|Total: 0||Total: 0||Total: 0|
In this situation, the transaction only affects the assets column of the equation. The transaction would have no impact on the company liabilities or shareholder’s equity to the right of the equation.
- Buying a new machine with a combination of cash and credit
Company A wants to purchase that same $500 machine, but they only have $250 in cash. The manufacturer says the company can buy the machine with a $250 deposit and pay off the rest on credit. This situation would mean the company gains a $500 debit for Equipment, a $250 credit for Accounts Payable, and minus $250 from Cash. Here’s how it would look in the formula;
|Total: +250||Total: +250||Total: 0|
The transaction would affect both sides of the accounting equation as it affects liabilities as well as assets.
Rearranging the Accounting Equation
The basic accounting equation isn’t set in stone. Some choose to rearrange it so that it looks like this;
Shareholder’s Equity = Assets – Liabilities
When arranged like this, the equation better highlights the relationship between the shareholder’s assets and company debt (liabilities). When expressed like this, the formula shows the shareholder equity is the balance left after removing liabilities from the assets. Entities that lend company – creditors – have the first claim to the assets of that company.
If a company were to go bankrupt, the assets are sold off, and the money from those sales goes to settle debts. Any money left over goes towards shareholders so they can make back some of their investment.
No matter how you present the accounting equation, you must remember it should always balance when calculated.