What Is the Accounting Equation? Everything you need to know

The accounting equation is one of the most fundamental concepts in accounting. It expresses the relationship between a company’s assets, liabilities, and equity. 

This post will explain the accounting equation, how it works, and why it’s crucial for accountants and business owners. 

We’ll also explore some of the applications and limitations of the accounting equation and how we can expand it to include more details.

What is the Accounting Equation?

The accounting equation, a.k.a. the balance sheet equation is a simple formula that shows how a company’s liabilities and equity finance its assets. 

The basic accounting equation formula is:

Assets = Liabilities + Equity

The above means that the total value of a company’s assets equals the sum of its debts and its owners’ claims. Assets are the company’s resources, such as cash, inventory, equipment, and accounts receivable. 

Liabilities are a company’s debts. A company’s obligations to others include loans, accounts payable, and taxes. 

Finally, equity represents the owners’ investment in the company.

The Accounting Equation and the Double-Entry Bookkeeping Practice

As mentioned above, the accounting equation is based on the principle of the double-entry accounting system. 

According to this principle, every financial transaction has two effects: one on the assets side and one on the liabilities and equity side.

The double-entry accounting system is an principle that helps guarantee that all accounting transactions are correctly recorded. Any minor mistake in bookkeeping will likely lead to an imbalance in this fundamental accounting equation.

(Source: investopedia.com) 

For example, if your company borrows $10,000 from a bank, its assets (cash) increase by $10,000, but its liabilities (loan) also increase by $10,000. The accounting equation remains balanced as both sides change by the same amount.

What Are the Key Elements of the Accounting Equation?

Let’s take a closer look at each element of the accounting equation and how to calculate them.

1. Assets

Assets are the economic resources a company owns or controls that provide future benefits. We can classify assets into two main categories according to their convertibility: current and non-current assets.

• Current assets can be converted into cash or used up within a year. They include cash, accounts receivable, inventory, and prepaid expenses.
• Non-current assets have a longer useful life and aren’t intended for sale within a year. They include capital assets (e.g., property, plant, equipment), intangible assets, and investments.
  

How to Calculate Your Assets

To calculate your total assets, you must add the value of all your current and non-current assets. You can use the following formula:

Total Assets = Current Assets + Non-Current Assets

Example

Suppose a company has the following assets:

Total Assets = ($15,000+$25,000+$30,000+$5,000)+($90,000+$20,000+$25,000)
Total Assets = $75,000 + $135,000
Total Assets = $210,000

How to protect your company’s assets

Asset protection is closely tied to the accounting equation, as the total amount your company holds in assets (as calculated in the example above) is the basis for calculating proper insurance coverage.

Protecting your company’s assets should always be a top priority. A well-crafted asset protection plan can include insurance coverage, setting up a foreign trust, emergency response protocols, and periodic risk assessments.

By prioritizing the security of your assets through a thoughtfully designed wealth protection plan, you can ensure stakeholders that your business stands resilient against external threats.

2. Liabilities

A company’s liabilities are the economic obligations to others, requiring future payments or services (like loan liabilities, short-term and long-term debt, etc.).

Like assets, we can classify liabilities into current and non-current liabilities.

• Current liabilities are due within one year of your business’s operating cycle, whichever is longer.
• Non-current liabilities are due after one year or beyond your business’s operating cycle.

Current liabilities include short-term loans, accounts payable, accrued expenses, taxes, etc. Non-current liabilities include long-term loans, notes payable, bonds, and deferred taxes.

(Source: twitter.com)

How to Calculate Your Liabilities

To determine your overall liabilities, you must add the value of all your current and non-current liabilities. You can use the following formula:

Total Liabilities = Current Liabilities + Non-Current Liabilities

Example

Suppose the same company as before has the following liabilities:

Total Liabilities = ($15,000 + $10,000 + $5,000 + $5,000) + ($45,000 + $40,000 + $10,000)
Total Liabilities = $35,000 + $95,000
Total Liabilities = $130,000

Contingent Liabilities: A Case Study in Credit Card Fraud Reports

In exploring the accounting equation and financial reporting, it’s crucial to consider all aspects of liabilities. 

In some cases, an obligation to pay a third party may or may not materialize depending on the outcome of an uncertain event, such as the result of a lawsuit. These are known as contingent liabilities.

While unfortunate, a credit card fraud report is a tangible example of a contingent liability. Correctly handling such incidents ensures the accuracy and integrity of a company’s financial reporting system and statements.

This simple example highlights the real-world application of the basic accounting equation in safeguarding a business’s financial health.

3. Shareholder Equity

Shareholder equity refers to the residual value of a company’s assets after deducting its liabilities. It represents the owners’ (or shareholders’) investment in the company and their claim on the net assets.

Shareholders’ equity can be classified into contributed capital and retained earnings.

• Contributed capital is the amount of money the owners have invested in the company, such as common and preferred stock.
• Retained earnings refer to the company’s profits that have been reinvested in the business instead of being distributed to the owners as dividends.

How to Calculate Your Shareholder Equity

To calculate your total equity, you must add up the value of your company’s sources of capital and retained earnings. You can use the following formula:

Total Equity = Contributed Capital + Retained Earnings

Alternatively, you can use the accounting equation to calculate your equity as the difference between assets and liabilities. You can use the following formula:

Total equity = Total Assets — Total Liabilities

Comparing the equity calculated with the accounting formula and the one based on the contributed capital and retained earnings is a benchmark of the quality of your bookkeeping. 

It’s the basis of the double-entry system. If both results don’t match the last cent, it’s evidence of a mistake.

That said, it’s important to note that both numbers coinciding don’t necessarily imply that everything is as it should be.

Example

Suppose a company has the following equity:

Total Equity = $60,000 + $5,000 + $15,000
Total Equity = $80,000

Using the accounting equation and the values of the assets and liabilities from the previous examples, the total equity of the company is:

Total equity = $210,000 − $130,000
Total Equity = $80,000

In this example, everything checks out.

The Accounting Equation and Business Structures

The accounting equation forms the foundation of financial statements and is closely related to a company’s business structure. 

While the accounting equation itself isn’t exclusive to any specific business structure, including LLCs (Limited Liability Companies), the role of an LLC in this equation is distinct due to its unique characteristics.

We can further elaborate on the role of an LLC in the accounting equation as follows:

Limited Liability Protection

The ‘Limited Liability’ aspect of an LLC is crucial. It means that the personal assets of the LLC members are separate from the business’s assets. 

This separation protects members’ personal assets from business liabilities.

Equity Contributions

Members of an LLC contribute equity, usually in the form of initial investments. This equity becomes a part of the equity component of the accounting equation. 

The members’ ownership interests are reflected in the equity section, emphasizing their claim on the LLC’s assets.

Applications of the Accounting Equation

The accounting equation is a theoretical concept but also a practical tool you can use for various purposes. Some of the applications of the accounting equation are:

• Calculating the three primary financial statements, i.e., the balance sheet, income statement, and statement of changes in equity.
• Providing the foundation of the double-entry bookkeeping system.
• Calculating a company’s worth in terms of its book value.
• Calculating income and retained earnings.

Additionally, you can visualize the accounting equation and its components using advanced visualization tools like Tableau.

Accounting software can help you see the double-entry system in action by showing how each accounting equation component changes after each financial transaction. 

You’ll also see how both sides of the equation rise and fall simultaneously, always remaining equal.

Limits of the Accounting Equation

The accounting equation is a valuable and powerful tool that can help understand and analyze a company’s financial situation. However, it has some limitations you should consider when using it:

• It doesn’t reflect the effects of inflation, impairment, depreciation, and amortization on the value of the assets and liabilities.
• It doesn’t capture the qualitative aspects of a company, such as its reputation, customer loyalty, brand recognition, etc., which may significantly impact its value and performance.
• It doesn’t account for the risks and uncertainties that a company may face, such as market fluctuations, competition, regulation, etc.
• It doesn’t consider the time value of money, which is the concept that money available today is worth more than money available in the future due to its potential earning capacity.

The Expanded Accounting Equation

We can expand the accounting equation to include more details and categories of the elements of the equation, such as revenues, expenses, gains, losses, dividends, and contributions.

We can thus write the resulting expanded accounting equation in different ways, such as:

Assets = Liabilities + Contributed capital + Retained earnings
Or
Assets = Liabilities + Contributed Capital (CC) + Beginning Retained Earnings (BRE) + Revenues + Gains – Expenses – Losses – Dividends

The expanded accounting equation shows how the different components of the income statement and the statement of changes in equity affect the balance sheet and how the financial activities of a company are interconnected.

The Accounting Equation Forms the Basis of Accounting

The accounting equation is a fundamental principle of accounting. It expresses the relationship between a company’s assets, liabilities, and equity and is the foundation for preparing and analyzing financial statements.

The accounting equation also provides a framework for recording and tracking a company’s business transactions using the double-entry accounting system, making it an essential tool for business owners.

Moreover, it can be used for various purposes in accounting and business, such as calculating a company’s net income and retained earnings and estimating a company’s worth. 

At the end of the day, it helps a stakeholder or potential investor understand the effects of different financial events on a company’s financial position and performance.