Accounting equation: Understanding the Accounting Equation Formula

Accounting equation: Understanding the Accounting Equation Formula

Accounting equation

The Accounting Equation is a fundamental principle stating that a company’s assets (i.e. resources) must always be equal to the sum of its liabilities and equity (i.e. funding sources). Accountants and members of a company’s financial team are the primary users of the accounting equation. Understanding how to use the formula is a crucial skill for accountants because it is a quick way to check that transactions are recorded correctly. The left side of the T Account shows a debit balance while the right side of the T account shows a credit balance. Account classes such as Assets & Expenses tend to have a debit balance, while account classes such as liabilities & income have a credit balance.

All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Working capital indicates whether a company will have the amount of money needed to pay its bills and other obligations when due. The global adherence to the double-entry accounting system makes the account keeping and tallying processes more standardized and more fool-proof. Debt is a liability, whether it is a long-term loan or a bill that is due to be paid.

Accounting Equation

The trial balance includes columns with total debit and total credit transactions at the bottom of the report. Equity is named Owner’s Equity, Shareholders’ Equity, or Stockholders’ Equity on the balance sheet. Business owners with a sole proprietorship and small businesses that aren’t corporations use Owner’s Equity. Corporations with shareholders may call Equity either Shareholders’ Equity or Stockholders’ Equity. This article gives a definition of accounting equation and explains double-entry bookkeeping. We show formulas for how to calculate it as a basic accounting equation and an expanded accounting equation.

Accounting equation

You can find a company’s assets, liabilities, and equity on a few key financial statements, including the balance sheet and the income statement. These financial statements give a quick overview of the company’s financial position. The accounting equation makes sure the balance sheet is balanced, showing that transactions are recorded accurately. Companies compute the accounting equation from their balance sheet. They prove that the financial statements balance and the double-entry accounting system works. The company’s assets are equal to the sum of its liabilities and equity.

Understanding the Accounting Equation Formula

A screenshot of Alphabet Inc Consolidated Balance Sheets from its 10-K annual report filing with the SEC for the year ended December 31, 2021, follows. As our example, we compute the accounting equation from the company’s balance sheet as of December 31, 2021. Essentially, the representation equates all uses of capital (assets) to all sources of capital, where debt capital leads to liabilities and equity capital leads to shareholders’ equity. The accounting equation sets the foundation of “double-entry” accounting since it shows a company’s asset purchases and how they were financed (i.e. the off-setting entries).

Land, buildings, fixtures & fittings, equipment, machinery all are classified as non-current assets. Furthermore, non-current assets also include intangible assets such as goodwill, brand name, patents & copyrights. The Accounting Equation is a vital formula to understand and consider when it comes to the financial health of your business. The accounting equation is a factor in almost every aspect of your business accounting. (1) as claims by creditors against the company’s assets, and (2) as sources (along with owner’s or stockholders’ equity) of the company’s assets. To make the Accounting Equation topic even easier to understand, we created a collection of premium materials called AccountingCoach PRO.

What Is the Accounting Equation?

The accounting equation is fundamental to the double-entry accounting system and, put simply, it states that the assets of a business must equal its liabilities & owner’s equity. Current assets include cash and cash equivalents, accounts receivable, inventory, and prepaid assets. Current liabilities are short-term financial obligations payable in cash within a year. Current liabilities include accounts payable, accrued expenses, and the short-term portion of debt. The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity.

  • For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount.
  • The balance sheet is one of the three main financial statements that depicts a company’s assets, liabilities, and equity sections at a specific point in time (i.e. a “snapshot”).
  • Under the double-entry accounting system, each recorded financial transaction results in adjustments to a minimum of two different accounts.
  • The Accounting Equation is the foundation of double-entry accounting because it displays that all assets are financed by borrowing money or paying with the money of the business’s shareholders.
  • As the fintech industry continues to expand, memorizing accounting equations will become obsolete.

Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting. The shareholders’ equity number is a company’s total assets minus its total liabilities. The accounting equation is also called the basic accounting equation or the balance sheet equation. The revenue a company shareholder can claim after debts have been paid is Shareholder Equity.

Accounting Equation in Practice

In our examples below, we show how a given transaction affects the accounting equation. We also show how the same transaction affects specific accounts by providing the journal entry that is used to record the transaction in the company’s general ledger. Liabilities are considered to be anything that is a claim against the company’s assets, such as payments or debts that the company owes. Ultimately, liabilities have a negative value representation, and are offset using the double accounting principle. For example, if your company secured a loan from a bank for $10,000, assets would increase by $10,000, as would liabilities. Accounting is full of various equations and formulas that are designed to help you quickly and effectively acquire information about the financial standing of your business.