The accounting equation, also known as the balance sheet equation, is the elementary equation purposeful in double-entry accounting. When starting a business, there are always these three parameters you consider first, assets, liabilities, and equity.
Each of these contributes significantly towards indicating the financial progress of your enterprise – whether you are making profits or not. An accounting equation, in this case, helps you comprehend the relationship among the three.
Parts Of An Accounting Equation
In this equation, assets equal the summation of all the liabilities and stakeholder’s equity.
I.e., Assets = Liabilities + Owner’s Equity
Assets, in this case, may include;
- Goodwill and many others
Liabilities could be; income taxes payable, loans payable, salaries and wages payable, accounts payable, and interest payable. The owner’s equity refers to the total amount you’ve put into your business as the owner or investor.
In expanded form, the accounting equation shows the relationship between the balance sheet and your business’ income statement. Now the equation becomes;
Assets = Liabilities + Owner’s Equity + Revenue – Expenses – Draws
From this equation, you realize that, if a company buys an asset, it loses the money asset but then gains the asset machinery. Meaning no loss. Also, by paying expenses, it gets utility assets such as electricity, labor, and so on that are beneficial to the development of the business.
Example Of A Balancing Sheet Situation
Johnstone is a company selling tractors. In their fiscal year report, their balance sheet gave the following statement.
- Total assets: $200 billion
- Summation of liabilities: $120 billion
- Total shareholders’ equity: $80 billion
By calculating the value on the right side, liabilities + stakeholder’s investment, we get $200, which equals the asset. It, therefore, means that the sheet is balancing and that there is no loss.
Key Reasons Why Accounting Equation Is So Important To Your Business
From the equation, you can see how essential each of the incorporated functions are to your business. If you, therefore, want to manage your business correctly, here are key reasons why you need to draw more focus to this equation.
It shows you your business’ financial status
Knowing the financial statement of your business is very crucial. This equation will show you whether it is profits you are making or losses. It will show you how much you have in the bank and whether the business can meet its financial goals.
It allows easy budgeting
Sheet balancing in your business will help you know if you can manage to buy a new asset for the company. Also, from it, it will be easier to weigh whether to settle your financial debts via asset or going for more liabilities.
For some businesses, balance sheets can be workable daily. That is even better. You can spot faults and pros within your business financial game path. Projecting finances from the balance sheet reports will, therefore, be very easy.
Take away notes on the accounting equation
- It forms the elementary basis of double-entry accounting
- The equation gives information on a business’ balance sheet. It shows the relationship there is between the assets, liabilities, and owner’s equity.
Wholesomely, the accounting equation gives a clear financial position of your business. As part of bookkeeping, it will help you know if you are making progress or not. Plus, it enables you to plan based on tangible financial records.