Accounting equation is used to define that the total assets of a company are equal to the liabilities and shareholders’ funds. Assets are resources that provide value to the company and are under the control of the company. While shareholders’ equity and liabilities are the money that the company owes for financing the assets.
An accounting equation or basic accounting equation is used in finances and accounts to define that the total assets of a company are equal to the liabilities and shareholders’ funds. This is also the base for the double-entry system. This ensures that the balance on both sides of the balance sheet remains the same. Hence, there is always a credit entry for a debit entry and vice versa.
The balance sheet has two columns, assets and liabilities which are a clear indicator of the financial position of the company. And the third section of this balance sheet includes the shareholders’ equity.
Assets are resources that provide value to the company and are under the control of the company. While shareholders’ equity and liabilities are the money that the company owes for financing the assets. If the assets are bought through debt, they go under the liabilities column, if the money is raised through shares, it goes under shareholders’ equity. This ensures that the true position of the business is reflected in the balance sheet.
What do assets comprise?
The assets comprise liquid assets, cash & cash equivalents and financial instruments like certificates of deposit and treasury bills. On the other hand, accounts receivable are the revenue that is yet to be received for the sale of products. Inventory is also a part of the asset.
Liability
Liabilities are the debt that a company owes to the people from whom they finance the resources and other essentials of the company to sustain its work. Debt can be long-term or short-term and both of its types are kinds of liability. Other costs include utilities, salaries, rents, wages and dividends payable.
Shareholder’s Equity
To find the shareholder’s equity, you need to subtract the assets from the liabilities. This means the money or dollars that the company would be left with if liquidation of the asset occurs and this money would be distributed to all the shareholders who have invested in the company.
Retained earnings are also included in the shareholders’ equity. It converts to the total earnings that are not provided to the shareholders in the form of dividends. These are the earnings that are retained or put aside for other future use.
The formula of the accounting equation
Assets = Liabilities + Shareholders’ Equity
The elements of this equation in the balance sheet are:
- The total assets on the balance sheet.
- All the liabilities have a separate column.
- Assets will be the same as the sum of liabilities and shareholders’ equity.
- Adding shareholders’ equity to the liabilities.
For instance, in a corporation, ABC, the contents of the balance sheet for a fiscal year are:
- Shareholders’ equity = $50 billion
- Assets = $170 billion
- Liabilities = $120 billion
Hence as per the equation, adding the liabilities ($120 billion) to shareholders’ equity ($50 billion) results in $170 billion in assets.
What is the double-entry system?
This accounting equation is the expression of the expanded, complex and multi-term display balance sheet. A company has to keep a record of these transactions to know about the financial position of the company. For instance, if the company takes a loan from a bank, the money that is borrowed will be shown on the balance sheet on the company’s assets on the liability side.
The double entry system is accepted globally as it simplifies and standardizes the tallying process and makes it almost free of error. The accounting equation ensures that the amounts are not mistaken or any item is not missed and it establishes the relationship that the liabilities and assets have between each other. Hence, verifying where the money inflows and outflows come from.
