Accounting equation

The basic accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a business. It is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as

$\text{Assets} = \text{Capital} + \text{Liabilities}$ ^[1][2]

$a = c + l$

In a corporation, capital represents the stockholders' equity. Since every business transaction affects at least two of a company’s accounts, the accounting equation will always be “in balance,” meaning the left side should always equal the right side. Thus, the accounting formula essentially shows that what the firm owns (its assets) is purchased by either what it owes (its liabilities) or by what its owners invest (its shareholders equity or capital).

For example: A student buys a computer for $945. To pay for the computer, the student uses $445 in cash and borrows $500 for the remainder. Now his assets are worth $945, liabilities are $500, and equity $445.

The formula can be rewritten:

Assets - Liabilities = (Shareholders' or Owners' Equity)^[1]

Now it shows owners' interest is equal to property (assets) minus debts (liabilities). Since in a corporation owners are shareholders, owner's interest is called shareholders' equity. Every accounting transaction affects at least one element of the equation, but always balances. Simplest transactions also include:^[3]

Transaction Number	Assets		Liabilities		Shareholder's Equity		Explanation
1	+	6,000			+	6,000	Issuing stocks for cash or other assets
2	+	10,000	+	10,000			Buying assets by borrowing money (taking a loan from a bank or simply buying on credit)
3	−	900	−	900			Selling assets for cash to pay off liabilities: both assets and liabilities are reduced
4	+	1,000	+	400	+	600	Buying assets by paying cash by shareholder's money (600) and by borrowing money (400)
5	+	700			+	700	Earning revenues
6	−	200			−	200	Paying expenses (e.g. rent or professional fees) or dividends
7			+	100	−	100	Recording expenses, but not paying them at the moment
8	−	500	−	500			Paying a debt that you owe
9		0		0		0	Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities

These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.

This equation is part of the transaction analysis model,^[4] for which we also write

Owners equity = Contributed Capital + Retained Earnings

Retained Earnings = Net Income − Dividends

and

Net Income = Income − Expenses

The equation resulting from making these substitutions in the accounting equation may be referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation.^[5]

Applications

The accounting equation is fundamental to the double-entry bookkeeping practice. Its applications in accountancy and economics are thus diverse.

Financial Statements

A company’s quarterly and annual reports are basically derived directly from the accounting equations used in bookkeeping practices. These equations, entered in a business’s general ledger, will provide the material that eventually makes up the foundation of a business’s financial statements. This includes expense reports, cash flow, interest and loan payments, salaries, and company investments.

Double Entry Bookkeeping System

Accounting equation plays a significant role as the foundation of the double entry bookkeeping system. This accounting system ensures that a company’s accounts are always balanced and that all financial transactions are documented in detail. The primary aim of the double entry system is to keep track of debits and credits, and ensure that the sum of these always matches up to the company assets, a calculation carried out by the accounting equation.

Income and Retained Earnings

Income and retained earnings of the accounting equation is also an essential component in computing, understanding, and analyzing a firm’s income statement. This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly. Thus, the accounting equation is an essential step in determining company profitability.

Company Worth

Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets.

Investments

Due to its role in determining a firm’s net worth, the accounting equation is an important tool for investors looking to measure a company’s holdings and debts at any particular time, and frequent calculations can indicate how steady or erratic a business’s financial dealings might be. This provides valuable information to creditors or banks that might be considering a loan application or investment in the company.^[6]

References

1. Meigs and Meigs. Financial Accounting, Fourth Edition. McGraw-Hill, 1983. pp.19-20.
2. Financial Accounting 5th Ed,p 47, HornGren, Harrison, Bamber, Best, Fraser, Willet, Pearson/Prenticehall, 2006
3. Accounting equation explanation with examples, accountingcoach.com.
4. Libby, Libby, and Short. Financial Accounting, Third Edition. McGraw-Hill, 2001. p.120
5. Wild.Financial Accounting, Third Edition.McGraw-Hill, 2005. p.13, ISBN 978-0078025389
6. "Accounting Equation". Retrieved 30 April 2013.