The accounting equation is the most fundamental equation of accounts. It is one of those equations from which a multitude of other equations is derived. It is the most fundamental equation upon which multitudes of other equations are based upon. It forms the primary principle of accounting, and it helps in maintaining the balance sheet of a company.
Furthermore, it forms the backbone of double-entry bookkeeping. Double-entry bookkeeping is when each financial transaction is noted two times, once on the debit side and once on the credit side, so books can be balanced. The books are balanced if both sides are equal to each other.
So, in other words, it is the universal equation in accounting, which forms the most basic principle of accounting. That is, assets must be equal to the sum of liabilities and shareholder’s equity or simply equity. The two sides must match. By manipulating this equation, balance sheets in the account books of a company are maintained.
The accounting equation is shown below:
Assets = Liabilities + Shareholder’s equity
This is the equation that forms the basis of double-entry bookkeeping. This equation can be manipulated in various ways to find what we want to know about a company from its balance sheet.
For example, if we want to find out the liabilities of a company, we just switch the equation as follows:
Liabilities = Assets – shareholder’s equity
Similarly, the shareholder’s equity can also be found on the balance sheet. This is because, in double-entry bookkeeping, both sides of the accounting equations must be balanced with each other. In other words, if we subtract one from the other, the answer must always be zero.
Consider, for example, a Company ABC which has bought a truck worth ten thousand dollars to transport its product and ship them to their customers. The company ABC paid for the truck by borrowing from the bank.
How this transaction is noted in the balance sheet by the double-entry bookkeeping method is shown below:
We can see from the above table that both sides are balanced. When the company borrowed the ten thousand dollars, the loan became a liability, but the company also gained an asset, the truck, worth ten thousand dollars.
So, the assets side of the balance sheet went up, but the liabilities side of the balance sheet also went up. In the end, the liabilities side becomes equal to the assets side.
There was no shareholder’s equity involved in this, so it is 0 in the balance sheet for purchasing a truck.
What falls under each section of the accounting equation?
There are three parts of an accounting equation: assets, liabilities, and shareholder’s equity. Each one of these three parts has a subclass.
Figure 1: Parts of an accounting equation
The three parts of an accounting equation and its subclasses are explained in detail below:
Assets are what a company owns. The main subclasses of assets are as follows:
Cash is a physical asset which a company holds. The value of Cash as an asset class arises from two reasons. One of the reasons is that it is convertible, and the second reason is that it is the most liquid asset anyone can have.
This can be a serious asset to have when a company is experiencing a cash-flow problem. That is why in a balance sheet under assets, Cash is the first one declared.
These are the payments that are to be paid to the company by its customer. These are also considered an asset, but accounts receivables are not as liquidate as Cash.
This is because sometimes, it can take months for a company to receive accounts receivables.
Inventory and equipment
Inventory and equipment are also asset classes. But, they are considered fixed assets. Especially, the equipment, because inventory can be sold faster, but it may take some time to sell the equipment.
Furthermore, the value of the equipment is based on depreciation. The older the equipment, the less the value it holds. This is why inventory and equipment are declared at the end of the asset side in the balance sheet.
Liabilities are what a company owes to other businesses or entities. The liabilities can be further divided into the following sub-classes:
Short term debt
Short-term debt is usually classified as a debt that is to be paid in under a year. The companies usually borrow for the short term to survive a recession or meet its near needs, such as payroll.
Long term debt
Any debt which is not to be paid within a year is called long-term debt. The companies usually borrow long-term debt to finance a new long-term project such as a new factory. On the liabilities side of a balance sheet, short-term and long-term debt are listed first of all.
These are the opposite of account receivables; they are payments that a company has to make to its suppliers.
Shareholder’s equity is further divided into two types. These two types are given as follows:
This is part of the capital which the shareholders retain.
Retained earnings are the share of the income retained by the business at the end of the accounting period. At the end of the balance sheet, retained earnings are declared.
The accounting equation is the primary equation used in accounting. It forms the base for double-entry bookkeeping, which forms the base of how every company on the surface of the Earth declares its financial conditions. So, an accountant must understand how it works.