Accounting Equation

What is the Purpose of Accounting Equation? 

The accounting equation serves as a fundamental principle in the practise of double-entry accounting, which is the basis for creating balance sheets. These balance sheets showcase an entity’s total assets, liabilities, and shareholder equity. 

Essentially, the accounting equation ensures that an entity’s use of capital (assets) remains in equilibrium with its sources of capital (debt and equity). In double entry accounting, every transaction is recorded in at least two financial accounts.  

For example, when an entity buys raw materials using cash, it records this transaction in both the inventory and cash accounts. This results in an increase in the inventory asset and a decrease in cash capital, in accordance with double entry accounting principles. 

Similarly, when an entity takes out a business loan, the borrowed funds increase assets while simultaneously increasing liabilities in the form of debt. These examples illustrate how double-entry accounting maintains balanced books. 

The accounting equation formalises this balance by stipulating that the total value of assets must always equal the combined value of equity and liabilities. This standardisation facilitates uniform management of accounts for global corporations and ensures balanced transactions at all levels. It establishes a clear relationship between each expense and its financing source, providing verifiable financial records. 

Balancing the Accounting Equation 

To ensure accuracy in financial transactions, accounting teams follow a straightforward process to balance the accounting equation. This involves examining each of the three components: 

Step 1: Identify the total assets of the entity for the relevant accounting period. 

Step 2: Sum up all liabilities recorded during the same accounting period. 

Step 3: Locate the shareholder’s equity and add this amount to the total liabilities. 

Step 4: Verify that the total assets are equal to the combined sum of total equity and liabilities. 

If the equation is not balanced, it indicates the need to carefully review the financial records to identify any inaccuracies or errors in recorded transactions. This meticulous review ensures the reliability and accuracy of the entity’s financial statements. 

Accounting Equation example

XYZ Corporation initiates its operations with certain financial transactions.  

Firstly, the company secures a loan of $40,000 from a bank. This loan is considered a liability as it represents an obligation to repay the borrowed amount in the future. 

Next, let’s examine ABC Corporation’s existing assets and equity. The company possesses $60,000 in cash and $30,000 worth of equipment. These resources constitute the company’s assets, representing the valuable resources it owns. 

In terms of equity, ABC Corporation’s owner has invested $50,000 into the business. This investment represents the owner’s stake or claim on the assets of the company. 

Now, let’s apply the accounting equation: Assets = Liabilities + Equity.  

By plugging in the numbers: 

Assets ($90,000) = Liabilities ($40,000) + Equity ($50,000). 

As we can see, the equation balances: the total value of the company’s assets ($90,000) equals the sum of its liabilities ($40,000) and equity ($50,000). This demonstrates that the company’s financial position is in equilibrium, with its assets financed by a combination of liabilities (the loan) and owner’s equity (the owner’s investment). 

The Expanded Accounting Equation 

Expanding the accounting equation allows for a more detailed representation of an entity’s financial position by incorporating additional categories such as revenues, expenses, gains, losses, dividends, and contributions. 

This expansion results in various formulations of the equation, such as: 

Assets = Liabilities + Contributed capital + Retained earnings 

or 

Assets = Liabilities + Contributed Capital (CC) + Beginning Retained Earnings (BRE) + Revenues + Gains – Expenses – Losses – Dividends 

The expanded accounting equation illustrates how the components of the income statement and the statement of changes in equity impact the balance sheet. It also demonstrates the interconnectedness of an entity’s financial activities, providing insights into how financial transactions affect its overall financial health and position. 

Practical Application of the Accounting Equation 

The accounting equation serves both as a theoretical concept and a practical tool with various applications, including: 

• Generating the three fundamental financial statements: the balance sheet, income statement, and statement of changes in equity. By adhering to the accounting equation, entities can accurately compile these statements, offering insights into their financial position, performance, and changes in equity over time. 
• Forming the basis of the double entry bookkeeping system, which is a fundamental accounting method used to record financial transactions. The accounting equation ensures that every transaction recorded in an entity’s books maintains balance, enhancing accuracy and reliability in financial reporting. 
• Assessing an entity’s book value, which represents its worth based on its financial statements. By utilising the accounting equation, entities can calculate their book value by subtracting liabilities from assets, providing an indication of their net worth as recorded in their financial records. 
• Calculating income and retained earnings, crucial metrics for evaluating an entity’s profitability and financial stability. The accounting equation facilitates the determination of income by comparing revenues to expenses, while retained earnings represent the portion of net income retained within the entity for future use or distribution to shareholders. 

Thus, the accounting equation serves as a versatile tool for entities in managing their finances, recording transactions accurately, and deriving key financial metrics essential for decision making and performance evaluation.