Basic Accounting Equation Explained

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basic accounting equation

An accounting equation is a formula that is used to record the relationship between various financial activities in a business. It is a simplified breakdown of the numbers, and the values entered in the balance sheet of a business or company. The equation defines the correlation between the liabilities, assets, and owners’ equity of a business.

This accounting equation acts as the foundation of the double entry bookkeeping system which implies that all the assets of a company should be equal to the liabilities in the book of accounts. In other words, all the entries made on the debit side of the balance sheet should also have a corresponding entry on the credit side of the balance sheet. It is because of this reason that the basic accounting equation is also referred to as the balance sheet equation.

The basic accounting equation is as follows:

ASSETS = LIABILITIES + EQUITY

What are Assets?

Anything that can be converted into cash is termed as an asset. Individuals and governments also own assets, but for a company, it should generate revenue or bring benefits to the owner. A business primarily owns two types of assets, namely, current and non-current assets.

Those assets that can be transformed into cash in less than a fiscal year or one operating cycle are referred to as current assets. These assets are used for facilitating day-to-day operational expenses like cash, marketable securities, accounts receivable, inventories, etc. On the other hand, non-current assets are also referred to as fixed assets because the company uses these for the production of goods and services having a life of more than one year. Non-current assets of a company can include plant and equipment, property, vehicles, machinery, buildings, land, furniture, etc.

What are Liabilities?

Liability refers to an obligation that a business owes to another entity. It is the total value that a company is expected to pay in the long term and short term. Just like assets, liabilities can also be classified as current and non-current depending upon the context. They include borrowings of a company from bank or individuals, a previous transaction that leads to an unsettled obligation, accounts payable, bonds payable, etc.

What is the Shareholders’ Equity?

Shareholders’ equity refers to the total value of money that has been raised by a company through the issue of shares. Shareholders’ equity is another name that is given to the amount of retained earnings that a company has. Since the shareholders invest some amount of money in a company, they expect to be paid with some dividend which is why it lies on the liabilities side of the company’s accounts book.

As an example, the balance sheet of Amazon.com’s as of year-end 2017 depicted the following scenario:

Liabilities:

As per public records, the current liabilities of Amazon were nearly $57.9 billion, while the long-term debt was $24.7 billion with miscellaneous liabilities of $21 billion. Hence, total liabilities sum up to be $103.6 billion.

Owners’ equity:

As of 2017, the capital surplus was $21.4 billion with retained earnings of $8.6 billion and other equity of ($2.29 billion). This component is negative. Hence the total owners’ equity is $27.72 billion

Now that we have the data for the owners’ equity and liabilities for Amazon, we can figure out the total assets by using the accounting equation. By adding up the liabilities ($103.6 billion) and the owners’ equity ($27.71 billion), we get total assets worth $131.31 billion.

The retained earnings component in the owners’ equity can be broken down into two parts, namely, revenue and expenses. Doing so helps us in understanding the relationship between the balance sheet and income statement of a company in the real world. The business earns revenues for providing products and services to its customers; however, expenses are the costs that are incurred by the business to produce or manufacture it’s offering. If revenues are higher than the costs, then it is referred to as a profitable venture.

The owner of the company can withdraw a salary or equity from the business itself. If the company is incorporated, then the salary could be in the form of a dividend that is paid by the corporation. However, if the company is a small and a sole proprietorship or a limited liability company or a partnership, then the owners can draw their salaries from the business.

Thus, the accounting formula after taking care of sales revenue and expenses can be re-written as follows.

ASSETS = LIABILITIES + OWNERS’ EQUITY + (REVENUE – EXPENSES) – DRAWS

It is crucial to be reminded that if the accounting equation of your business or company does not balance then the financial reports will lose their integrity. As a result of this, it would be difficult for you to keep track of the financial transactions taking place inside and outside the business. Accounting equation serves as a system of checks and balances while ensuring that all the relevant accounts have received their entries and the essence of each transaction is recorded.

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