The Accounting Equation: What Is It, Formula, and Examples

Using the balance sheet, a financial analyst can calculate a number of financial ratios to determine how well a company is performing, how efficient is it is, and how liquid it is. Changes in the balance sheet are used to calculate cash flow in the cash flow statement. Taking time to learn the accounting equation and to recognise the dual aspect of every transaction will help you to understand the fundamentals of accounting. Whatever happens, the transaction will always result in the accounting equation balancing. The accounting equation is a core principle in the double-entry bookkeeping system, wherein each transaction must affect at a bare minimum two of the three accounts, i.e. a debit and credit entry.

The balance is maintained because every business transaction affects at least two of a company’s accounts. 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. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as the double-entry accounting or bookkeeping system. The balance sheet is a more detailed reflection of the accounting equation.

Accounting equation

The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets. The accounting equation helps to assess whether the business transactions carried out by the company are being accurately reflected in its books and accounts. This straightforward relationship between assets, liabilities, accounting equation and equity is considered to be the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the debit side has a corresponding entry (or coverage) on the credit side. Double-entry accounting is a system that ensures that accounting and transaction equation should be equal as it affects both sides.

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

The Balance Sheet

The rationale is that the assets belonging to a company must have been funded somehow, i.e. the money used to purchase the assets did not just appear out of thin air to state the obvious. While very small or simple businesses can sometimes make single-entry accounting work, everyone else is wise to https://www.bookstime.com/ use the double-entry accounting—in part because it has error-avoidance built right in. This number is the sum of total earnings that were not paid to shareholders as dividends. Assets include cash and cash equivalents or liquid assets, which may include Treasury bills and certificates of deposit.

• The three main parts of the balance sheet are assets, liabilities, and owner’s equity, which comprise this equation’s components.
• In the coming sections, you will learn more about the different kinds of financial statements accountants generate for businesses.
• Equity represents the portion of company assets that shareholders or partners own.
• The accounting equation is the basic element of the balance sheet and the primary principle of accounting.
• A liability, in its simplest terms, is an amount of money owed to another person or organization.
• Due within the year, current liabilities on a balance sheet include accounts payable, wages or payroll payable and taxes payable.