Accounting Equation Definition Basic Example How To Interpret

Accounting Equation Definition

Below is the Accounting Equation

Assets = Liabilities + Shareholders Equity

Accounting Equation is based on the double-entry bookkeeping system, which means that all assets should be equal to all liabilities in the book of accounts. All the entries made to the debit side of a balance sheet should have a corresponding credit entry on the balance sheet. Thus it is also known as the balance sheet equationBalance Sheet EquationBalance Sheet Formula is a fundamental accounting equation which mentions that, for a business, the sum of its owner’s equity & the total liabilities equal to its total assets, i.e., Assets = Equity + Liabilitiesread more.

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Basic Accounting Equation

Breaking down the Equation

Assets: This is the value of a company’s items; they may be tangible or intangible but belong to the company.A liability: This is a term for the total value that a company must pay in the short term or the long term.Shareholders’ Equity: Shareholder’s EquityShareholder’s EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders’ Equity Statement on the balance sheet details the change in the value of shareholder’s equity from the beginning to the end of an accounting period.read more is the amount of money a company has raised through its issue of shares. Alternatively, it is also the amount of retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more of a company. As the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more invest their money in the company, they must be paid with some amount of returns, which is why this is a liability in the company’s account books.

Hence, the total assetsTotal AssetsTotal Assets is the sum of a company’s current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more should always be equal to the total liabilities in a balance sheet, which fundamentally forms the basis of the whole accounting system of any company when it follows the double-entry bookkeeping system.

Example #1

On December 1, 2007, Kartik started his business, FastTrack Movers and Packers. The first transaction that Kartik will record for his company is his investment of $20,000 in exchange for 5,000 shares of FastTrack Movers & Packers common stock. There are no revenues because the company earned no delivery fees on December 1, and there were no expenses. How will this transaction get recorded in the balance sheet?

Cash & Common Stocks

Common Stock will be increased when the corporation issues sharesCorporation Issues SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner’s equity on the Company’s balance sheet.read more of stock in exchange for cash (or some other asset)Retained Earnings will increase when the corporation earns a profit, and there will be a decrease when the corporation has a net lossNet LossNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet.read moreCore link between a company’s balance sheet and income statement

Example #2

A double-entry bookkeeping system helps us understand the flow of any particular transaction from the source to the end. Let’s take another basic, expanded accounting equationExpanded Accounting EquationExpanded Accounting Equation refers to the expanded version of the basic accounting equation for a specific corporation or sole proprietor, providing information on the corporation’s financial transactions such as assets, liabilities, share capital, income, expenses, and withdrawals.read more example.

When there is a purchase of an asset in a company, the purchase amount should also be withdrawn from some account in the company (generally a Cash account). Hence, the account from which the amount is withdrawn gets credited, and there needs to be an account debited for the asset purchased (the account related to the asset purchased gets debited).

Consider the below entries:

On December 27, Joe started a new company by investing $15,000 as equity.On January 3, Joe purchased an office table for his company, which cost him $5,000.He paid wages for his labor on January 5, totaling $15,000.On January 10, he received a contract from his clients, and they paid him $2,000.On January 13, Joe received another contract for which the client paid $4,000 in advance.On January 15, he completed the service contract received on January 13, and the client paid the remaining amount of $8,000.

The Journal entries for the above transactions are as below:

The corresponding entries in a balance sheet as of January 15 should be as below:

It is seen that the total credit amount equals the total debt amount. It is fundamental to the double-entry bookkeeping system of accounting, which helps us understand from the illustration above that total assets should be equal to total liabilities.

In this illustration, Assets are – Cash, Furniture A/C, and Accounts ReceivableAccounts ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more; Liabilities are Wage expenses and Service Revenue.

If we refer to any balance sheet, we can realize that the assets and liabilities and the shareholder’s equity are represented as of a particular date and time. Hence, as of January 15, only three accounts exist with a balance – Cash, Furniture A/C, and Service Revenue (the rest get net off during the period of the whole transaction by January 15). Only those accounts that exist with a balance (positive or negative) on a particular date are reflected on the balance sheet.

Alternatively, we can also understand that total liabilities can be derived if the only asset value is mentioned. The owner’s equity can also be determined if total assets and total liabilities are available. The basic accounting equation formula can also be used as below:

Total Liabilities = Total Assets – Shareholders Equity

Shareholders Equity = Total Assets – Total Liabilities

Hence, this forms the basis of many analyses for market investors, financial analysts, research analystsResearch AnalystsResearch analyst is a profession where the main task includes research on specific fields, analyzing the facts and figures, interpreting the analysis, and finally presenting the same to a structured audience that can relate to marketing, finance, operations.read more, and other financial institutions.

Accounting equation in an Income Statement

Not only does the balance sheet reflect the basic accounting equation as implemented, but also the income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more.

An income statement is prepared to reflect the company’s total expenses and total income to calculate the net income for different purposes. This statement is also prepared in the same conjunction as the balance sheet. However, a little differently applied.Here, we do not have total assets and liabilities. Still, the statement is prepared so that if an expense is credited, it will have an equal and opposite entry in debt in a related ledger accountLedger AccountLedger in accounting records and processes a firm’s financial data, taken from journal entries. This becomes an important financial record for future reference. It is used for creating financial statements. It is also known as the second book of entry.read more.The income statement includes the accounts which directly refer to a company’s income or expenses like Cost of Goods Sold, Tax expenses, andInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company’s balance sheet.read more Interest PayableInterest PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company’s balance sheet.read more expenses.

Final Thoughts

It is understood that the double-entry book-entry accounting system is followed globally and adheres to the rules of debitRules Of DebitDebit represents either an increase in a company’s expenses or a decline in its revenue. read more and credit entries. These entries should tally to each other at the end of a particular period, and if there is a gap in total balances, it needs to be investigated. This system makes accounting a lot easier by creating a relationship between the expense/liability and cause of expense/liability (or income/asset and source of income/asset). We need to understand the underlying concept and thumb rule of accountingRule Of AccountingAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. read more, which relates to debit and credit entries at the root level. Thus, although the accounting equation formula seems like a one-liner, it contains a lot of meaning and can be explored deeper with complex expense entries.

Accounting Equation Definition Basic Example How To Interpret