Accounting Equation: Assets, Liabilities, and Equity
To run a financially stable business, it is important to know the basic accounting equation principles and how to apply them. The accounting equation formula is a fundamental component of managing your company’s balance sheet. It forms the basis of double-entry bookkeeping and is used to ensure the accuracy of each entry in the journal.
Read on to learn more about a business’s equity, assets, and liabilities, and learn how to apply accounting equation formulas.
Assets and Liabilities
The key difference between the assets and liabilities is that the former is something the business owns while the latter is something the business owes. Assets are economically profitable and include items such as inventory, equipment, cash, and short-term investments. Liabilities are the services the business has not performed and the amount it owes.
To be successful, a business must have more assets than liabilities. A business with more debt will not be able to pay it off and should consider taking quick action to improve cash flow.
What Is The Accounting Equation Formula?
The accounting equation formula is the financial representation of a company in terms of assets, liabilities, and equity. It helps decision-makers determine how much money a company has in each category. Often, professionals with a financial function, such as accountants, use accounting equation formulas to supplement a company’s balance sheet. However, in a small business or sole proprietorship, a senior manager or business owner can do these calculations.
The Accounting Equation Formula Is As Follows:
Assets = Liabilities + Equity
When you add up total liabilities and total equity, the result is equal to total assets. If the two numbers are not equal, review your calculation to make sure you entered everything correctly. Check each account on the balance sheet and compare it to your company’s financial records to see if you missed anything. This can help ensure that you are reporting accurate figures when filing your tax return or in the case of a financial audit.
After reviewing the balance sheet and performing the necessary calculations, you determine that you have total assets of $300,000, total liabilities of $250,000, and $50,000 of equity.
The Formula Will Look Like This:
300,000 USD = 250,000 USD + 50,000 USD
300,000 USD = 300,000 USD
What Is Assets?
An asset is anything that has monetary value and belongs to your business. Assets contribute to day-to-day business operations and drive growth and financial stability. There Are Two Main Types Of Assets:
1) short-term assets and
2) long-term or long-term assets.
Current assets are assets that your business expects to consume, use, or convert to cash during a financial year, while long-term assets are assets that your organization will hold for a period of time. Longer than one financial year.
Here are some examples of short- and long-term assets, along with information on how to calculate them:
Current Assets Example:
- What accounts can receive
- Prepaid debt
- Short-term investments (Treasury bills, high-yield savings accounts, and government bonds)
Examples Of Long-Term Assets:
- Property or land
- Intellectual Property
- Copyright or trademark
When calculating assets, use the following standard accounting equation formula or equation:
Total assets = Current assets + Long-term assets
To find out your company’s total assets and compare them to liabilities and equity, first identify the different asset classes on your balance sheet. Once you’ve determined your total short-term and long-term assets, add them together to calculate your total assets.
Total assets = $100,000 (short-term assets) + $200,000 (long-term assets)
Total assets = 300,000 USD
What is legal liability?
Liabilities include all debts owed by a company to consumers, partners, or organizations. Like assets, liabilities can be divided into two main categories:
1) short-term debt and
2) long-term debt.
Short-term debt includes all the debts your business has to pay during the financial year, while long-term debt includes all the obligations that will not be repaid during the financial year but over an extended period of time.
The following are examples of short-term debt and long-term debt:
Examples Of Short-Term Debt:
- Income Tax
- Short-term bank loans
- Notes payable
Examples Of Long-Term Debt:
- Obligation to pay
- Pension payment
- Deferred income tax
- Long-term loan
Liabilities And Expenses
It is important to distinguish between liabilities and expenses. They are similar but have key differences. First, expenses are recognized on the income statement of the business and represent the costs involved in running your business. It is important to note that costs can be paid immediately in cash. Delaying payment of an expense creates liability.
By subtracting expenses from income, you can calculate the net income of your business. If expenses exceed income, your organization could be in financial trouble.
- Found on the income statement
- Stick with income
- Expenses related to running the business and generating income
- Found on the balance sheet
- Due now or in the future
- Obligations and debts
Calculation Of Accounts Payable
You can calculate your company’s liabilities using the following formula:
Liabilities = Assets – Equity
To determine your company’s total liabilities, find the total assets and equity figures on the balance sheet. You may need to apply the equity formula before proceeding.
Liabilities = $300,000 (assets) – $50,000 (equity)
Liabilities = $250,000
What Is Equity?
Equity or shareholder equity represents the approximate amount that would be left if you liquidated all of the company’s assets to pay off its debt. It also represents the hypothetical amount that shareholders will receive in return for their investment.
Here Are Some Examples:
- Retained earnings
- Preferred shares
- Common sense
- Paid up capital
You can calculate equity using the following equation:
Equity = Assets – Liabilities
To determine how much equity you can hold for investors, determine the total assets and liabilities. You can usually find these numbers at the bottom of the balance sheet.
Equity = $300,000 (total assets) – $250,000 (total liabilities)
Equity = $50,000
The Importance Of The Accounting Equation
Understanding a company’s equity, assets, and liabilities is essential for any trader using a double-entry bookkeeping system. The accounting equation ensures that the balance sheet is balanced and that each record is recorded correctly. It also helps shareholders understand how much their investment is worth in the event of a liquidation.
Being familiar with these Generally Accepted Accounting Equation Principles (GAAP) and what they mean is important for business leaders to be able to run a profitable operation with healthy cash flow.
Frequently Asked Questions About Your Business’s Assets And Liabilities
Is Land An Asset Or A Liability?
Land is a long-term fixed asset, as the length of time you would normally expect to own it can be longer than a year. The exception would be if you plan to liquidate the land in the next financial year. Land cannot be depreciated and is often a company’s most durable asset.
What Is Contingent Liability?
Contingent liabilities are a gray area because they reflect contingent liabilities that may arise in the future. Examples include product warranties, possible lawsuits, and ongoing investigations. When you can estimate a contingent liability, you should record it on your balance sheet. If it cannot be estimated, you will need to disclose it.
What Is The Relationship Between the Assets, Liabilities, And Equity?
The value of a company’s total liabilities is equal to the sum of the difference between total assets and equity. Therefore, even though the accounting equation suggests assets = liabilities + equity, it is also possible to re-adjust the formula to liabilities = assets – equity. If your business accumulates more debt instead of creating more assets, its equity position will decrease.