Accounting Equation - Overview, Formula, and Examples

Accounting Equation - Overview, Formula, and Examples

Here we will learn about what is the accounting equation and balance sheets and how to calculate the balance sheet. 

We will also learn about the formulas of accounting equations that is accounting equation formula.

What is the Accounting Equation?

The accounting equation states that assets equal liabilities plus shareholder equity, demonstrating that a company's entire obligations plus shareholder equity equal its total assets. 

Double-entry bookkeeping's foundation is the unmistakable relationship between a company's liabilities, assets, and equity. 

A company's balance sheet serves as the data source for its accounting equations. Equity can refer to stockholders' equity, owners' equity, or shareholders' equity.

Similar to other equations, the fundamental accounting equation can have its third term solved if the first two terms are known. 

Total Assets - Total Equity = Total Liabilities, for instance, or Total Assets - Total Liabilities = Total Equity. 

A negative sign is used to change a term in the accounting equation from the right side to the left side.

What are the Different Names for Equity on a Balance Sheet?

On the balance sheet, equity is labelled as Owner's Equity, Shareholders' Equity, or Stockholders' Equity. 

Owner's equity is used by sole proprietors and small firms that are not corporations. 

Equity can be referred to as Shareholders' Equity or Stockholders' Equity in corporations having shareholders.

Accounting Equations Rules

The term "accounting equation" refers to two fundamental equations that make up double-entry and accrual accounting systems.

The following are two fundamental accounting equation rules that set the single-entry system apart from the double-entry system and the accrual system apart from cash basis accounting:

  • The basic accounting formula, represented as Assets = Liabilities + Equities, is the first.

Assets = Liabilities + Shareholder’s Equity

  • The second one, known as the "Expanded Accounting Equation," combines the primary equation Debit = Credit with the second equation, which is known as the basic equation.

It only derives its status from the accrual system of accounting, so it is inapplicable in a cash-based, single-entry accounting system.

Accounting Equation formula

Asset = Liability + Owner's equity ensures that the balance sheet is always in balance.

The "Balance Sheet Equation" is also known as the "Basic Accounting Equation," which is important to note. Because of the following equation, the balance sheet balances every time:

Assets = Liabilities + Owners Equities

The three main parts of the balance sheet are assets, liabilities, and owner's equity, which comprise this equation's components. 

Bookkeepers and accountants use the above equation to guarantee that the "balance"—i.e., that both sides of the equation are always equal—always holds.

When firms employ a double-entry bookkeeping system, the accounting equation is an extension of the "Basic Equation" that adds another fundamental rule that governs every accounting transaction.

Debits = Credits

The following is a summary of this accounting equation:

  • Every event affecting accounts should have an equal debit and credit balance.
  • Every pair of "entries" that comes after a transaction has the same balance because the total of all debit entries must equal the total of all credit entries throughout any given time period.

This equation acts as a crucial built-in error-checking mechanism for accountants creating financial statements.

Types of Accounting Equation and Formulae correlation

The accounting equation, commonly referred to as the "Balance Sheet Equation," is the foundation of all financial accounting. 

The various types of fundamental accounting equations are as follows:

  • Owner's Equity (Capital) = Assets - Liabilities
  •  Asset = Liability + Capital
  •  Liabilities = Assets - Capital

Liabilities + Owner's Equity = Assets

This accounting equation formula for the balance sheet reveals that all of the assets held by the firm are either financed with owner equity, the amount that the company should owe to third parties, such as suppliers, or borrowings, such as loans.

Assets – Owner's Equity = Liabilities

Your liabilities, which come in the shape of debts to suppliers, banks, and other third parties, represent the difference between your assets and the owner's investment in the business.

Liabilities - Assets equals Owners' Equity.

The value of assets owned solely by owner equity can be calculated using this equation.

In our attempt to establish a correlation, we observe that gains or incomes will raise owner equity while costs or losses will lower it.

What is Double-Entry Accounting (Bookkeeping)?

In double-entry accounting or bookkeeping, total debits on the left must equal total credits on the right. 

This is true for every commercial transaction and journal entry. As a result of this, the financial statements are balanced.

The monthly trial balance is a list of account names from the chart of accounts, along with their total account balances or amounts. 

Before posting transactions to the general ledger for the accounting cycle, total debits and credits must be equal.

During the 14th century, merchants in Italy began to use double-entry bookkeeping as a manual system.

Accounting software is a double-entry accounting system that creates the trial balance automatically. 

The trial balance includes columns at the bottom of the report with total debit and total credit transactions.

Examples of the Accounting Equation

1. Paying Cash for a Machine

Company XYZ wants to spend all of its cash on a $500 machine. Cash would experience a credit (a drop in an asset), and Equipment would experience a debit (a rise in an asset) as a result of this transaction. 

The following would be the net impact on the accounting equation:

The only part of the equation that this transaction alters is the assets; the right side of the equation's liabilities and shareholder equity is unaffected.

2. Buying a Machine using Credit and Cash

Company XYZ only has $250 in cash on hand and wants to buy a $500 machine. 

The business is permitted to pay this machine a $250 down payment, but it must pay the manufacturer the entire balance. 

It would result in a debit ($500 rise in asset) to Equipment, a credit ($250 increase in liability), and a credit ($250 decrease in asset) to Cash. The following would be the net impact on the accounting equation:

Both the left and the right sides of the accounting equation are changed by this transaction, adding $250 to each.

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Conclusion

Accounting equation formula memorization will become obsolete as the fintech sector develops. 

The key is to automate manual operations while releasing your human labour to work on things with higher value.

FAQs related to Accounting Equation

1. What is the fundamental equation for accounting?

Asset = Liabilities + Equity is the basic accounting equation.

2. What is an accounting equation, and how might you illustrate it?

Assets = Liabilities + Shareholder's Equity is the formula for the accounting equation. The basis for double-entry accounting is this equation. Each transaction has an impact on both sides of the accounting equation under double-entry accounting.

3. What Constitutes the Accounting Equation's Three Components?

The three variables in the accounting equation are assets, liabilities, and shareholders' equity. The calculation is simple: The sum of a company's assets is equal to the sum of its liabilities and shareholders' equity. The widely accepted double-entry bookkeeping technique is designed to reflect all of a company's assets accurately.

4. How Important Is the Accounting Equation?

The accounting equation depicts the relationship between assets, liabilities, and equity—the three items on a balance sheet. If all other factors are equal, a company's equity will rise when its assets do, and vice versa. Reducing liabilities, such as by paying off debt, will raise equity, while adding liabilities will decrease equity. Modern accounting techniques depend on these fundamental ideas to function.

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