A basic accounting equation is used to generate financial statements, regardless of the size of a business. So, what exactly is the accounting formula and why does it exist?
Double-entry accounting systems are based on the equation: Total Assets = Liabilities + Equity.
Assets refer to any valuable resources the business owns. Liabilities, on the other hand, describe any outstanding obligations. Combining the two parts of the equation calculates how the company’s assets are financed. This is useful for businesses to balance their financial statements. In order to have accurate results, any entries made on the debit side of a balance sheet should have a corresponding entry on the credit side.
Why do we need accounting equations?
To answer this question, it is key to understand double-entry accounting. This is built around a balance sheet, showing a balance of total assets, liabilities and shareholder equity. This sheet helps the business owner ensure that uses of assets are balanced with sources of capital.
In order for double-entry accounting to work, all business transactions must be noted in at least two financial accounts. For example, if a business purchases something using cash, this would need to be noted in its inventory accounts as the purchased material is an increase in assets. The purchase should then also be marked as a reduction in capital in the company's balance sheet because capital was spent on it.
Similarly, when a company borrows money, it gains assets. At the same time, this raises the company's liability in the form of debt. Double-entry accounting maintains financial records in balance and helps business owners keep an eye on their financial position. This is where the accounting equation concept comes in. The two sides of the equation must always be equal to one another.
It's also easier for international businesses to keep track of their accounts because double-entry accounting is a global norm. It's also beneficial on a smaller scale by maintaining all transactions in balance and establishing a reliable connection between each expenditure and its source of funding.
The accounting equation formula and its elements
Assets can include anything from cash to merchandise. Everything the firm owns that reflects its value is included here, including equipment, prepaid expenses, and property.
Liabilities are the second component of the accounting equation. This category covers any obligations to third parties, such as accounts payable, deferred revenue, and other debts, that the business may have.
Finally, there is equity. This category includes the worth of any investments made in the company, whether by owners or shareholders. After all liabilities have been satisfied, the owner's equity will equal everything left over from the assets.
A balance sheet is made up of these three elements of the equation.
How to have a stable balance sheet equation?
- When considering how to balance the accounting equation, you must consider each of the three components:
- Step 1: Identify the total assets of the company for the accounting period
- Step 2: Identify the total liabilities for the same period
- Step 3: Identify the shareholder’s equity and add this figure to the company's liabilities
- Step 4: Make sure the total assets of the company are equal to its total equity and liabilities
If the equation is incorrect, it's time to go through the financial records to find out if any transactions were recorded incorrectly. The equation also gives you the option of rearranging it to reveal any missing components.