In the world of finance, every number tells a story. Behind the financial statements lies the foundational concept that governs the movement of money in every business: the accounting equation.
At first glance, it might seem like a simple formula – Assets = Liabilities + Equity – but this equation is far more than just numbers on paper. It’s the backbone of financial transparency, the lens through which we see the economic health of a business.
So, what is the accounting equation, and why is it important?
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What is the Accounting Equation?
Also called the balance sheet equation, the accounting equation is a fundamental principle in accounting that forms the foundation of a company’s financial statements. It shows the relationship between a company’s assets, liabilities, and equity and is expressed as:
Assets = Liabilities + Equity
The accounting equation ensures that a company’s statement of financial position (balance sheet) stays balanced since every transaction a company makes affects at least two accounts in at least one of the following three components: assets, liabilities and equity.
In essence, the accounting equation reflects the idea that what a company owns (assets) is funded by either borrowing (liabilities) or owner/shareholder contributions (equity).
Importance of the Accounting Equation
The accounting equation is significant for several reasons, including the following.
The accounting equation is the foundation for double-entry accounting – it forms the backbone of double-entry accounting, where every transaction affects at least two accounts. When a company takes out a cash loan (liability), its cash account (asset) is also affected. The accounting equation will balance once the asset and liability accounts are updated accurately.
The accounting equation ensures accuracy – because the equation must balance, it highlights any errors in the financial statements. Ignoring fraudulent activities, when the accounting equation balances, it suggests that a company accurately reflects all transactions in its financial statements. External stakeholders can be confident that the information presented best reflects the company’s financial health and performance and is appropriate to base decisions on.
To summarise, the accounting equation plays a crucial role in ensuring the accuracy of a company’s financial statements. It reinforces the double-entry system in accounting, where every transaction affects at least two accounts and confirms the integrity and useability of the financial statements when balanced.
Breakdown of Accounting Equation Components
The accounting equation comprises three components: assets, liabilities and equity. But what are they exactly?
Assets
Assets are present economic resources that an entity controls due to a past event with the potential to produce future benefits. If a company bought (the past event) a factory (the present economic resource) to manufacture goods for sale (future benefit), then the factory is considered an asset.
In simpler terms, an asset is something an entity owns that can generate future benefits.
Liabilities
Liabilities are present obligations of an entity to transfer an economic resource that can produce future benefits due to past events. If a company took out a bank loan (the past event), it must repay it (the present obligation to transfer) with cash (the economic resource that can produce future benefits).
In simpler terms, liabilities are things an entity owes that can generate future benefits.
Equity
Equity is the residual interest in an entity’s assets belonging to shareholders after deducting all liabilities. It reflects what shareholders would receive if all the company’s assets were sold and all liabilities settled.
In essence, equity is the net worth of an entity.
Bearing these in mind, how does the accounting equation work?
How and Why The Equation Balances with Examples
The accounting equation forms the foundation of double-entry accounting, where every transaction affects at least two accounts. Understanding double-entry accounting is fundamental to grasping how and why the accounting equation always balances.
Understanding Double-Entry Accounting
As the name suggests, double-entry accounting is a system where every transaction is recorded twice – once as a debit and once as a credit – ensuring the accounting equation remains balanced.
A debit (Dr) entry increases the value of assets and expenses and decreases the value of liabilities, equity and revenue. If a company buys a factory (an asset), the factory account would be debited (increased) by the amount paid for the factory. On the other hand, if a company pays down a bank loan (a liability), the bank loan account would be debited (decreased) by the amount paid down.
A credit (Cr) entry decreases the value of assets and expenses and increases the value of liabilities, equity and revenue. If a company sells some of its land (an asset), the land account would be credited (reduced) by the amount sold. On the contrary, if a company takes on a new bank loan (a liability), the bank loan account would be credited (increased) by the amount taken.
Because double-entry accounting is based on the principle that every transaction has a dual effect on a company’s finances, the total amount debited must equal the total amount credited. If this is not the case, the accounting equation will not balance.
Examples of Double-Entry Accounting and How The Equation Balances
Double-entry accounting usually occurs between asset and asset, asset and liability, and asset and equity. This is generally the case, but there are times when three accounts are affected by a transaction.
The following examples show how transactions are recorded and how the accounting equation remains balanced.
Example 1: Two Account Double-Entry Accounting (Asset and Asset)
Transaction: Purchased machinery by cheque for £100,000.
How the transaction is recorded:
- Debit Machinery – £100,000
- Credit Bank – £100,000
Since the company bought machinery by cheque, the machinery account value has increased, and the bank account value has decreased. Because both are assets, the machinery account was debited to increase its value, and the bank account was credited to reduce its value.
Remember: to increase asset values, you debit the account. To decrease asset values, you credit the account.
The accounting equation remains balanced as the total value of assets doesn’t change. If the company had no machinery before this transaction and a bank account balance of £300,000, total assets would be £300,000. By purchasing machinery by cheque for £100,000, the machinery account would be £100,000, and the bank account balance would be £200,000. Total assets still equal £300,000.
Assuming the owners contributed the initial £300,000 to the company’s bank account:
Assets (£300,000) = Liabilities (£0) + Equity (£300,000)
If the machinery was sold and the proceeds received by cheque, the transaction would be recorded as follows:
- Debit Bank – £100,000
- Credit Machinery – £100,000
The accounting equation would remain balanced as the company’s bank balance would increase to £300,000 and machinery would be reduced to £0:
Assets (£300,000) = Liabilities (£0) + Equity (£300,000)
Example 2: Two Account Double-Entry Accounting (Asset and Liability)
Transaction: Took out a bank loan for £500,000 cash.
How the transaction is recorded:
- Debit Cash – £500,000
- Credit Bank loan – £500,000
Since the company took out a new loan and received cash, both the cash account and loan account values have increased. Because cash is an asset, the account was debited to increase its value. The loan account was credited to increase its value.
Remember: to increase asset values, you debit the account. To increase liability values, you credit the account.
The accounting equation remains balanced as there is a corresponding increase in the total value of assets and liabilities of £500,000. Assuming no equity:
Assets (£500,000) = Liabilities (£500,000) + Equity (£0)
If the company were to pay back £200,000 of the loan, the transaction would be recorded as follows:
- Debit Bank loan – £200,000 (reducing the bank loan amount)
- Credit Cash – £200,000 (using cash to reduce the bank loan amount)
The accounting equation would remain balanced:
Assets (£300,000) = Liabilities (£300,000) + Equity (£0)
Example 3: Three Account Double-Entry Accounting (Asset and Equity)
Transaction: Issued 100,000 new shares with a par value of £1 for £1.50.
How the transaction is recorded:
- Debit Cash – £150,000
- Credit Share capital – £100,000
- Credit Share premium – £50,000
*Share capital is the total amount, stated at par value (the value of the shares when they were first sold), that owners/shareholders contributed to a company.
*Share premium represents the surplus investors pay for buying shares above par value.
Because new shares were issued to raise cash, entries must be made to reflect the change in share capital, the change in share premium, and the change in cash.
To find the amount credited to the share capital account, multiply the total newly issued shares by their par value (100,000 new shares x £1 par value). To find the amount credited to the share premium account, multiply the total issued shares by the difference between the par value and the issue price (100,000 x £0.50).
The amount debited to the cash account is found by multiplying the total number of newly issued shares by the issuing price (100,000 x £1.50).
Remember: to increase asset values, you debit the account. To increase equity values, you credit the account.
The accounting equation remains balanced as there is a corresponding increase in the total values of assets and equity of £150,000. Assuming no liabilities:
Assets (£150,000) = Liabilities (£0) + Equity (£150,000)
Summary
In summary, the accounting equation is a cornerstone of financial reporting, providing a structured framework to understand the relationship between what a company owns (assets), owes (liabilities), and the residual interest of shareholders (equity).
Encapsulating this relationship in the simple yet profound formula (Assets = Liabilities + Equity) not only reinforces the principles of double-entry accounting but also ensures the integrity and accuracy of financial statements.
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