Definition Of The Accounting Equation
The accounting equation, also known as the foundation of double accounting, states that at any point in the accounting period, the total value of assets will always equal the total value of the liabilities of the company. Organization and of the owner’s capital. , i.e., equity; in other words, in an accounting equation, the value of total liabilities should always be equal to the value of full credits.
The accounting equation helps to understand the relationship between assets, liabilities, and equity. An asset is a resource owned by an organization that helps to generate future economic benefits. On the other hand, a liability is a financial obligation that results in an outflow of economic resources, i.e., the outflow of cash or any other asset. Equity is the owner’s business amount, i.e., capital or reserve and surplus. It is also the difference between active and passive.
The accounting equation forms the basis of double-entry bookkeeping, and every transaction affects both sides of the equation. Basically, some practical examples with real-world scenarios of current assets are cash, inventory, accounts receivable, equipment, etc. Liabilities include short-term loans, long-term liabilities, accounts payable, and equity, including equity, retained earnings, etc. The determination affects only one side of the equation, i.e., just the asset or the liability, since selling on credit will only increase (accounts receivable) and decrease (inventory) the asset.
Assets = Liability + Owners Equity
Assets = Total assets (current asset + noncurrent assets)
Liability = Total liability (current liability + noncurrent liability)
Owners Equity = Total shareholder’s equity (share capital + retained earnings)
Practical Examples With Real-World Scenarios Of Accounting Equations
Different practical examples are mentioned below:
The company paid $100000 cash for a machine that cost $200000. Cash is outflowed, machines are inflowed, and a liability is created for the balance.
Liability Shareholder Equity
$200000 – – Machine Purchased
($100000) – – Cash Paid
– $10000 – Liability Created
Applying 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. Donald has 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
The accounting equations show the impact of the following transactions: Mac Buy Raw Materials with $10,000 Credit.
Preference shares issued 10,000 USD
Bank loan of 10,000 USD
Loan to be repaid 5,000 USD
Purchases on credit will increase assets by $10,000 and, at the same time, increase liabilities by $10,000.
Along with the preferred stock issuance, it resulted in an increase in preferred stock capital with a concurrent cash gain of $10,000.
With the loan amount, the bank balance and liabilities increase by $10,000.
With loan repayments, liabilities and bank balances are reduced by $5,000.
As such, the accounting equation always matches all the above transactions, i.e., the increase/decrease occurs with the same amount.
There are various applications of the accounting equation certainly in the fields of accounting and economics:
The company’s annual and quarterly reports are prepared with the help of accounting records using the double-entry bookkeeping method. However, general ledger entries using equations provide the data that make up the financial statements. This includes cash, expense reports, interest and loan payments, company investments and salary entries, and more.
It represents a company’s revenue and retained earnings, which is essential in calculating, analyzing, and understanding a company’s income statement. Moreover, this is the profit or loss of the business, determined by calculating /applying accounting equation. It helps the company determine earned income and prepare a report on retained earnings. The analysis of these earnings predicts future earnings trends, helping businesses make timely decisions.
The accounting equation forms the basic basis of the double-entry bookkeeping system. A double-entry bookkeeping system is intended to keep track of all the debits and credits of an organization and to ensure that its funds always match. It is based on the fact that all transactions are equally valid and are also used to transfer total entries from the main ledger to the A/c ledger.
The equation helps to evaluate the net worth of the business. It calculates the value of the company’s assets and liabilities, allowing the owner to determine the total value of its assets. The ledger shows that the depreciated value of an asset will be less than its value in the secondary market.
It is essential that investors always evaluate a company’s ability to measure assets and liabilities. However, these regular calculations help analyze a company’s financial position and measure how healthy it is.
- It is used to analyze whether assets are financed with debt or with capital from business owners using the double-entry bookkeeping method.
- It distinguishes between a company’s assets, liabilities, and equity.
- It gives a clear picture of the financial position of any business.
- The accounting equation is intended to determine the progress of business in a given day.
- It tells us how much money a company has in the bank and how well it can meet all its financial obligations.
- It also helps us to assess the profit or loss of a business since its inception.
- Accounting equations determine whether assets can be purchased if liabilities need to be paid off with assets, or if new liabilities need to be created.
- It helps accounting professionals and accountants maintain accuracy.
- The accounting equation is based on a double accounting system to help balance the equation and also limit the risk of errors.
- It helps maintain business performance by identifying debits and credits of business transactions. Basically, It is an essential tool for preparing or performing reverse financial entries that make it easy to correct errors.
- It helps to determine the growth of a business, i.e., an upward or downward trend.
- The accounting equation does not measure events or circumstances that have no monetary value.
- If an event, such as management, reputation, or loyalty, has no monetary value, then it has no place in the accounting equation.
- The accounting equation uses a predetermined cost to value values , ignoring factors like inflation, price changes, etc., and thus loses the relevance of accounting information.
- While humans make up the accounting equation, there is a rate of error and intentional fraud that is harder to detect.
Above all the accounting equation represents a company’s valuable resources expressing their obligations in the form of liabilities. Thus, it helps shareholders determine the value of the company and establish a relationship between them.