What you should know about accounting equation: Examples, formula, and explanation
Are you looking for the accounting equation examples? You don’t know where to start? Don’t worry, in this article, we will explain all!
The accounting equation is a basic principle of accounting and a fundamental element of the balance sheet, which is one of the most important financial statements of every company. Maybe you already heard about the assets of the business and how those assets are financed, either through liabilities, debt, or equity. But how to balance these elements? Here is why we need an accounting equation!
Discover the formula, examples, and the expanded version of the accounting equation in this article!
What is the accounting equation?
Definition
The fundamental accounting equation, also known as the balance sheet equation, represents the relationship between the asset, the liability, and the equity of a company. Assets are all the properties that a company owns and on the other hand, liabilities are what the company owes.
The total of the left-hand column of the balance sheet is equal to the total of the right-hand column. Indeed, by convention, the assets are presented on the right and the liabilities on the left of a balance sheet. Taking into account the basic accounting principles, the informed entrepreneur will be at his best when the assets of his balance sheet are equal or "balanced" with the liabilities.
It is the basis of the double-entry accounting system. For each transaction, the total debits equal the total credits. We will explain what double-entry accounting is down below, just keep reading!
Formula
The financial situation of any company is measured by three fundamental accounting indicators, which can be summed up in an equality, which accountants call "the balance sheet". The principle is summarized by the formula below:
Assets = Liabilities + Owner’s Equity
Or, in the other way, we can have:
Owner’s Equity = Assets - Liabilities
3 essential elements of the accounting equation formula
Assets
Assets are the resources that the business owns, and from which the company is likely to benefit in the future.
Examples of assets are cash, accounts receivable, inventory of product assets (food, beverages), inventory of material assets (customer supplies, office supplies, dishes, etc.), furniture, billing and collection system, computer equipment, land, and buildings.
The lenders of a business have the legal and economic rights to the assets of that business. For example, a creditor who lends money to a restaurant owner has a right, in a legal sense, to a portion of the business' assets until the business repays its debt. The owner of the business also has an interest in the assets because they have invested in the business.
Liabilities
Liability is what the business owes to third parties. It is also defined as all the financial assets available for use by the company. As we have seen, the liability is composed, on the one hand, of the debts contracted by the company with third parties and, on the other hand, of the funds left by the owners (or shareholders) at the company's disposal.
It is quite simple: in order to operate assets, the company must acquire them. It, therefore, owes money to third parties who provide the assets to finance the assets. For example, the company's debts will be rent, salaries to be paid, interest paid to lenders, taxes, etc.
Owner’s Equity
The equity is what remains of the investment of the owners of the company, by the difference between the value of the assets and the value of the debts.
Since the sum of the assets cannot logically exceed the value of the assets (which the company finds by making debts that complement the owners' contribution), the accounting equation can also be verified as follows:
Owner’s Equity = Assets - Liabilities
In other words, equity is the sum of the investments risked by the owners of the company, whether they have paid funds to acquire the company's property (shares or stocks), or whether they have decided to reinvest their acquired profits in the company (instead of allocating them to themselves from available cash).
If the business owner takes the money out, the equity will be decreased. For example, John takes £150 from the cashier of his store to buy himself a shirt. Because he is taking £150 out of his company, £150 will be reduced from the equity of his company.
The sum of these two types of assets constitutes the liability of the balance sheet, according to accounting terminology. Consequently, we can also express our equation simply as:
Assets = Liabilities
Examples of the accounting equation
To help you understand how to use the accounting equation, here are some examples!
Example 1:
Using the formula of accounting equation calculation above to find the missing factors.
- Assets = £200,000; Liabilities = £30,000; Equity = ?
- Assets = £100,000; Liabilities = ?; Equity = £80,000
- Assets = ?; Liabilities + Equity = £600,000
Reponse:
By applying the formula Assets = Liabilities + Owner’s Equity, we can easily solve this:
- Equity = Assets - Liabilities = £200,000 - £30,000 = £170,000
- Liabilities = Assets - Equity = £100,000 - £80,000 = £20,000
- Assets = Liabilities + Equity = £600,000
Example 2:
Here is the balance sheet of a company. Calculate the net assets of the company in 2 way (from the owner’s equity and from the assets)
| Assets | Liabilities | ||
| Fixed assets | £200 000 (1) | Capital | £50 000 |
| Intangible assets | £1 500 000 | Reserves | £1 000 000 |
| Inventory | £250 000 | Investment grants | £10 000 |
| Accounts receivable | £400 000 | Provisions | £100 000 (3) |
| Prepared expenses | £10 000 | Shareholder’s loan | £100 000 |
| Supplies | £60 000 | Debts | £270 000 |
| Asset conversion gap | £20 000 (2) | Liability conversion gap | £10 000 |
| Total | £2 440 000 | Total | £2 440 000 |
- including facility fees: £50 000 (1)
- provisioned up to: £15 000 (2)
- including £15 000 of provision for the exchange loss (3)
The net asset result will be calculated as following:
- From the owner’s equity:
Assets = £50 000 (capital) + £1 000 000 (reserves) + £10 000 (investment grants) + £10 000 (liability conversion gap) - £50 000 (facility fees) - £15 000 (provision for exchange loss) = £1 005 000
- From the assets:
Assets = £200 000 (fixed assets) - £50 000 (facility fees) + £1 500 000 (intangible assets) + £250 000 (inventory) + £400 000 (accounts receivable) + £10 000 (prepared expenses) + £60 000 (supplies) + £20 000 (Asset conversion gap) - £15 000 (provisions) - (£100 000 + £270 000 + £100 000) (Provisions + loans + debts) = £1 005 000
The expanded version of the accounting equation
The expanded version of the accounting equation is got from the common accounting equation and further outlines the various differentials of a company's value.
By separating each value into parts, experts can improve the thought of how the profit is utilized, reinvested in the business, or kept in real money.
The extended version of the accounting equation subtleties the value of each element of the fundamental accounting equation. The normal type of the accounting equation is:
Assets = Liabilities + Owner’s Equity
The expanded version of the accounting equation is:
Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Revenue - Expenses - Dividends.
- Contributed Capital is capital given by the first investors (otherwise called Paid-In Capital)
- Beginning Retained Earnings (BRE) is the income not disseminated to shareholders from the past period
- Revenue is what's produced from the progressing activity of the company
- Expenses are the costs brought about to run activities of the business
- Dividends are the profit disseminated to the shareholders of the company
About the double-entry bookkeeping method
Double-entry accounting is a system that describes and lists the business processes involved in the financial management of a company.
Based on specific techniques, it involves entries between two separate accounts, one account, and one counterpart account, and is particularly suited to companies dealing with numerous financial inputs and outputs.
This is in contrast to simple accounting (used by small businesses), which summarizes the inflow and outflow of money in a simple comparison of the two accounts.
The two concepts of debit and credit are in conflict. However, they are complementary! To the same operation (commercial transaction) corresponds at least a debit in one account and a credit in another.
We call an asset a credit, which can be a reduction in assets, a loan, an increase in income, etc. The entry of a credit in the company's accounts means that an asset is used.
The debit, on the other hand, is a use of this asset. This can be a purchase, an increase in the company's assets, a reduction in income, or an increase in expenses.
In summary, for each financial transaction, one of the two accounts must be debited and the other credited in order to establish a counterpart. This principle makes it possible to balance the accounts and have equal credit and debit balances.
Why is the accounting equation important?
The accounting equation is significant because it impacts the connection between the three parts: asset, liability, and equity. All else being equivalent, a company's value will increase when its assets increase, as well as the other way around.
Additionally, adding liability will reduce the value, while decreasing liability, for example, squaring away obligation, will build value. These fundamental ideas are caught by the accounting equation and are vital for current accounting techniques.
The balance sheet must be balanced, i.e. the level of assets must correspond to the level of liability. To illustrate this principle, let's take the example of a company that makes a profit. It increases its level of assets, but also its level of liabilities since this profit becomes a debt of the company towards its partners (share capital).
Another example is that the cash obtained (current assets) thanks to a short-term bank loan also represents a debt for the company since it will have to repay these sums, etc.
Limits of the accounting equation
Although the balance sheet has to be balanced, the accounting equation can't let financial shareholders know how their company’s financial health is performing.
Financial shareholders should analyze the result and choose for themselves whether the company has such a large number or a lack of liabilities, insufficient assets, or maybe an excessive number of assets, or regardless of whether it has adequate financing to guarantee long-term development.
In conclusion, understanding and knowing how to calculate the accounting equation is very important for every business. Remember that the basic accounting equation has 3 elements: assets, liabilities, and equity. The extended accounting equation helps the businesses know how profits are utilized, reinvested in the business, or kept in real cash. Follow our steps and don’t let accounting be your obstacle any more!