The accounting equation is calculated using the balance sheet. They demonstrate that the financial accounts are balanced and that the double-entry accounting system is functional. The assets of the corporation equal the total of its liabilities and equity. This post will explain the accounting equation formula in relation to liabilities, assets, and capital.
What is the Accounting Equation?
The accounting equation is a formula that indicates the entire assets of a corporation are equal to the sum of its liabilities and shareholders’ equity (Assets = Liabilities + Equity). The unambiguous relationship between a company’s liabilities, assets, and equity is the foundation of double-entry accounting. The balance sheet is the source of a company’s accounting equation numbers. Shareholders’ equity, stockholders’ equity, or owner’s equity are all examples of equity.
If you know the first two terms of the basic accounting equation formula, you can solve for the third. Total Assets – Total Liabilities = Total Equity, for example, or Total Assets – Total Equity = Total Liabilities. A negative sign is used to move a term from the right to the left side of an accounting equation.
What is the Significance of the Accounting Equation Formula?
Using the accounting formula provides you with an accurate picture of your company’s financial health. When calculating the company’s assets and liabilities, the total value of its assets should ideally surpass the entire value of its obligations.
If the equation gets unbalanced, you’ll need to find a means to increase income in order to keep the business running and prevent going bankrupt. While all businesses must borrow money in order to operate, it becomes troublesome when your liabilities outpace the value of your business assets. When you do incur new debt, prioritize loans that promote growth.
What is an Asset?
An asset is something that has monetary value to your business. Assets can help your business’s daily operations, such as a facility you own and use as a warehouse, as well as support financial development or stability (for example, intellectual property you can sell and license).
There are two types of assets: current assets and non-current assets. A current asset only retains its value for around one fiscal year after purchase, whereas a non-current asset adds value to your organization for a longer period of time.
Current assets include the following:
- Accounts payable
- Prepaid obligations
- Inventory in cash
- Treasury bills, high-yield savings accounts, and government bonds are examples of short-term investments.
- Insurance purchased in advance
Non-current assets include the following:
- Office furniture
- Land or property with equipment
- Intellectual property rights
- Trademarks or copyrights
- Patents
- Marketplace courtesy
- The domain name of your firm
- Lists of customers
- Customer relationships
You should also differentiate between intangible and physical corporate assets. You can get your hands on actual assets such as items, cars, supplies, and raw materials. Intangible assets, on the other hand, cannot be touched but are nevertheless very real. Intangible assets include your company’s reputation in the marketplace and copyrighted intellectual property.
Asset calculation
To calculate the worth of your company’s assets, you can use either the normal accounting formula or the following equation:
Total assets are the sum of current and non-current assets.
To compare the total assets of your company to the sum of your liabilities and shareholder equity, first identify the various types of assets on your balance sheet. Once you’ve determined your total current and non-current assets, add them up to determine your total assets.
As an example:
Total Assets = $100,000 in current assets plus $200,000 in non-current assets
Assets totaling $300,000
What Is A Liability?
Liabilities are all outstanding bills owed by your company to customers, partners, vendors, supplies, or financial institutions. Liabilities, like assets, can be divided into two categories: There are two types of liabilities: current liabilities and non-current liabilities. Current liabilities must be repaid within a fiscal year, but non-current liabilities have repayment dates that are greater than a fiscal year.
Current liability examples are:
- Accounts receivable
- Dividends
- Wages
- Income taxation
- Bank loans for a short period of time
- Accounts payable
Non-current liabilities include the following:
- Bonds to be paid
- Pension payments
- Debentures
- Tax deferral
- Contracts that must be completed
Liabilities Calculation
The following formula can be used to calculate your company’s liabilities:
Liabilities = assets – shareholder equity.
Find total assets and equity on your balance sheet to determine the entire amount of obligations. You may need to use the equity formula before proceeding.
As an example:
Liabilities = $300,000 (Assets) – $50,000 (Shareholders’ Equity).
Liabilities are equal to $250,000
What is Equity?
Equity, often known as shareholder’s equity, is the amount of money that would be left over if all of the company’s assets were liquidated to pay off its liabilities. This figure also indicates the amount of money that shareholders would get in exchange for their initial investment.
Common equity examples include:
- Earnings retained
- Stock of preference
- The common stock
- Invested capital
Determining equity
Use the following equation to calculate equity:
Equity = assets – liabilities.
Establish the entire number of assets and liabilities to establish the amount of equity your investors could potentially get. These data are normally found towards the bottom of your balance sheet.
As an example:
$300,000 (Total Assets) – $250,000 (Total Liabilities) = Equity
Equity = $50,000
You can better monitor your company’s financial soundness if you grasp the accounting formula and its significance in your organization.
What is the Capital Accounting Equation?
In its most basic form, the accounting equation is Capital = assets – liabilities.
Capital is defined as a company’s residual interest in its assets after deducting all of its liabilities (what would be left if the company sold all of its assets and satisfied all of its liabilities). It is referred to as ‘Equity’ in the case of a limited liability firm.
Capital fundamentally symbolizes the amount of money invested in the business by the owners, as well as any accrued retained profits or losses. For example, if you were to start a sole trade business with a $1,000 investment, the accounts of the business would reflect that it had $1,000 of cash available on the first day of trading and that this originated from an investment made by you. You, as the business owner, would ultimately own the funds.
Concerning the Double-Entry System
The accounting equation is a succinct statement of a balance sheet’s sophisticated, enlarged, and multi-item layout.
Essentially, the representation equates all capital uses (assets) to all capital sources, with debt capital leading to liabilities and equity capital leading to shareholders’ equity.
Every business transaction will be represented in at least two accounts for a company that keeps accurate accounts. For example, if a corporation obtains a loan from a bank, the borrowed funds will be shown in the company’s balance sheet as both a gain in assets and an increase in loan liabilities.
When a company buys raw materials and pays in cash, it increases the company’s inventory (an asset) while decreasing cash capital (another asset). Because every transaction carried out by a company affects two or more accounts, the accounting system is known as double-entry accounting.
The double-entry method assures that the accounting equation is always balanced, which means that the left side value of the equation always equals the right side value.
In other words, the total value of all assets will always equal the entire value of all liabilities and shareholders’ equity.
The global adoption of the double-entry accounting system standardizes and secures the accounting and tallying operations.
The accounting equation ensures that all entries in the books and records are verified, and that there is a verifiable relationship between each liability (or expense) and its matching source; or between each piece of income (or asset) and its source.
Limits of The Accounting Equation
Despite the fact that the balance sheet always balances, the accounting equation cannot inform investors how well a company is functioning. Investors must analyze the figures to determine whether the company has too many or too few obligations, insufficient or excessive assets, or whether its funding is adequate to enable long-term growth.
What Is the Difference Between the Accounting Equation and the Working Capital Formula?
The accounting equation calculates total assets, total liabilities, and total equity. This method is not the same as working capital, which is based on current assets and current liabilities.
Working capital is a metric for liquidity. Current Assets – Current Liabilities is the working capital formula.
Cash and cash equivalents, accounts receivable, inventory, and prepaid assets are examples of current assets. Current liabilities are financial obligations that are due in cash within a year. Accounts payable, accrued expenses, and the short-term part of a debt are examples of current liabilities.
Working capital determines if a company has enough money to pay its invoices and other commitments on time.
What is the Extended Accounting Equation?
The basic accounting equation (Assets = Liabilities + Shareholders’ Equity) is lengthened by the extended accounting equation. The formula displays items from the balance sheet’s shareholders’ Equity section.
Total Assets = Total Liabilities + CC +/- AOCIL + BRE + R – E – D – SR is the expanded accounting equation.
Where terms from the balance sheet’s Shareholder’s Equity section include:
CC stands for Contributed Capital.
AOCIL has been accumulated. Other Combined Income (Loss)
BRE has begun. Earnings Retained
R stands for Revenue.
E stands for Expenses.
D stands for Dividends (paid).
SR stands for Stock Repurchases.
CC, or Contributed Capital, reflects Share Capital in this enlarged accounting equation. AOCIL is added or deleted for profit or loss. The Beginning of Retained Earnings Retained Earnings + Revenue – Expenses – Dividends – Stock Repurchases.
AOCIL, or Accumulated Other Comprehensive Income (Loss), is a component of shareholders’ equity that is separate from contributed capital and retained earnings. Unrealized gains or losses on available for sale securities, foreign currency translation gains or losses, and pension plan-related items, such as profits or losses, prior pension service expenses, and credits, are all included in AOCIL.
If the shares are not retired, they are referred to as treasury stock. Treasury stock purchases and sales are reported in retained earnings and paid-in capital. The journal entry is determined by the specifics of the transaction.
If there is preferred stock, it is combined with common stock. Beginning Retained Earnings plus year-to-date additions to Retained Earnings (from Revenue minus Expenses = Net Income) minus Dividends paid minus Share Repurchases equals Retained Earnings.
The Balance Sheet is still required for EAE. Please keep in mind that you will also require the Income Statement and perhaps the comprehensive Statement of Stockholders’ Equity.
Not all businesses will pay dividends, repurchase stock, or have other comprehensive income or loss.
What Is an Example Of The Accounting Equation In Real Life?
Exxon Mobil Corporation’s (XOM) balance sheet in millions as of December 31, 2019 is shown below:
- The total value of the assets was $362,597.
- The total amount of obligations was $163,659
- The total amount of equity was $198,938.
The accounting equation is as follows:
Accounting equation: $163,659 (total liabilities) + $198,938 (equity) = $362,597 (total assets for the period).
What Are the Golden Rules of Accounting?
#1. Deduct from the receiver and credit from the giver
With personal accounts, the rule of debiting the receiver and crediting the giver applies. A personal account is a general ledger account that belongs to an individual or a business.
Debit the account if you receive something. If you give something, make sure to credit the account.
#2. Debit what comes in and credit what leaves.
Apply the second golden rule to real-world accounts. Permanent accounts are another name for real accounts. Real accounts do not close at the end of the year. Their amounts are instead carried forward to the next accounting period.
A real account can be either an asset or a liability or an equity account. Contra assets, liability, and equity accounts are also included in real accounts.
When anything new enters your firm (for example, an asset), debit the account. When something leaves your company, credit the account.
#3. Credit income and profits minus debit expenses and losses
The last golden rule of accounting concerns nominal accounts. A nominal account is one that you close at the conclusion of each fiscal period. Temporary accounts are another name for nominal accounts. Revenue, expense, and gain and loss accounts are examples of temporary or nominal accounts.
If your company incurs an expense or suffers a loss, debit the account. If your company has to record income or gain, credit the account.
To Summarize
Memorizing accounting equations will become useless as the fintech industry grows. The key to success is to free up your human labor to focus on value-added tasks while automating manual operations. So much accounting can be delegated to a computer. Thus, allowing you to make better use of your resources.
Related Articles
- WHAT ARE ASSETS AND LIABILITIES: Definition, Differences and Examples
- Retained Earnings: How It Works with Examples
- LIABILITIES: Meaning & What You Should Know
- EXPANDED ACCOUNTING EQUATION: Overview, Formula & Calculator
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