The accounting equation implies that the enterprise’s total assets coincide with the amount of its liabilities and stock capital.
This direct correlation between assets, obligations, and equity is deemed to be the basis of the double-entry record-keeping system. The accounting equation guarantees that the balance continues to be in trim. In other words, the entry that is recorded in the debit should be reflected in the credit.
The accounting equation is also known as the balance sheet one.
Essence of Accounting Equation
Financial standing of any enterprise is centered around two strategic constituencies of the balance sheet: assets and obligations. Ownership capital comes as the third part.
The accounting equation represents an interrelation of these above-mentioned constituencies. Assets are called valuable tools managed by the firm, whereas liabilities include the sources due to which they are formed, along with equity capital.
So that the accounting equation enables estimating whether the firm’s financial operations are shown correctly in its account book.
As stated above, the following parts are listed in the accounting equation:
- Assets, including monetary means and their equivalents, as well as Treasury bills and depositary certificates. Accounts receivables may be considered a form of assets, anticipating the amount of money payable to the enterprise by its customers. At the same time, the major assets of the enterprise are equipment units, building facilities, and partnership property.
- Liabilities, implying debts of the firm and its operating costs. In fact, these are obligations that need to be paid. Examples include long-term loans. Expenditures allude to rental charges, taxes, wages, utilities, and dividends payable.
- Equity capital, representing the enterprise’s total assets subtracting its total obligations. The term can be defined as the overall number of funds that a firm would possess after the above-mentioned calculations. Retained earnings are also a component of the notion. It is the sum of financial facilities that wasn’t refunded to stockholders as dividends. Actually, these earnings may be saved for future transactions.
In fact, the accounting equation is calculated as follows.
Notably, the balance sheet introduces particular parts that make a contribution to the accounting equation:
- Arrange the enterprise’s total assets on the balance sheet for a certain time interval.
- Sum up all obligations, which have to be listed on a separate basis in the balance sheet.
- Calculate total equity capital and then add the resulting number to total obligations.
- Assets will amount to the sum of obligations and owner’s capital.
Accounting Equation in real life
Let's illustrate the above calculations with a particular example. A case in study can be the corporation A that is the leading retail establishment.
The enterprise’s balance sheet for the this accounting year is presented below:
- Total assets: $190 billion.
- Total equity capital: $120 billion.
- Total obligations: $70 billion.
According to the formula, the first figure ($190 billion) coincides with the sum of owner’s capital and obligations ($120 billion + $70 billion). It means that the corporation reported correctly.
Double-entry accounting system
The accounting equation represents a shorthand expression for the complicated and expanded presentation of a balance sheet. For the firm maintaining accurate accounts, every financial operation will be reflected in two of these accounts. In case the company arranges a loan from a bank, the borrowed monetary means should be presented both as gains in total assets and a hike in liabilities.
If the enterprise purchases raw materials and pays in cash, it would lead to the growth of inventory, which is one of the enterprise’s assets. At the same time, the monetary capital (another firm’s asset) would decrease. Due to the fact that every transaction should be expressed in two or more accounts, the record-keeping system is known as the double-entry one.
This practice guarantees that there is the accounting equation being in trim. It implies both sides having the same resulting numbers.
Therefore, the double-entry accounting systems simplify the process of record-keeping making it more reliable. The accounting equation, in turn, provides an examination of all entries.
Boundaries of Accounting Equation
In fact, the accounting equation has certain limits concerning a good performance of the enterprise. So that investors are meant to understand the numbers, and, as a consequence, determine whether the firm is worth funding or not. There are various indicators, including assets, obligations, and owner’s equity.