The accounting equation is the foundation of the double-entry accounting system in use today. It is quite simple to understand and to use. It represent the relationship between the assets, liabilities and the equity of a business. It can be best described in an equation:
In a corporation, the capital mentioned in the equation, would be the shareholder’s equity. Every business transaction affects at least two of the company’s accounts. The accounting equation will always be in balance. It means that the left side should always be equal o the right. The accounting formula will always show the what the firm acquired by what it owes or what its owners has invested.
Formulas that work with the accounting equation:
Shareholder’s or Owners Equity= Assets-Liabilities.
This formula shows that the owner’s interest is equal to asses minus the liabilities. Since a corporation has shareholders, the owner’s equity is called shareholder’s equity. Every transaction will affect at least one factor in the equation and it will always balance.
This equation is part of the transaction model which can be explained with the following equations:
Owners equity = Contributed Capital + Retained Earnings.
Retained Earnings = Net Income − Dividends.
Net Income = Income − Expenses.
The equation that results in the breakdown of the basic accounting equation, may even be referred to as expanded accounting equations. It actually serves to explain the whole makeup of the original equation.
Uses of the accounting equation:
It is fundamental to the double-entry accounting system. The uses in the accounting and economic sectors are very diverse.
A company’s reports are basically created from all the equations. When they are used, they provide the necessary data that must be used in the financial statements. Some examples would be: expense reports, investments and salaries.
Double-entry accounting system:
The accounting equation plays a huge role as the foundation of the bookkeeping system. This system ensure that a company’s accounts are always balanced. All financial transactions are documented in detail. The primary goal of the double entry system is to keep track of debits and credits. It must also ensure that the company’s statements balance.
Income and retained earnings:
The use of the accounting equation is also essential for computing, understanding and analyzing a company’s financial statement. This statement shows the profit and losses which are determined by the equation. In other terms, it allows the business to calculate its revenue and to prepare a statement of retained earnings. It will allow the business to predict future income and adjust its practices accordingly. An overall conclusion would be that without the equation, the profitability of the business could not be calculated.
The equation is also fundamental to calculate the net worth of a company. Due to the fact that the accounting equation is used to calculate the company’s holdings and debts, the owners can ascertain the value of the company’s assets.
The equation is also an important tool for investors who would like to measure the company’s holdings and debt at any moment. Frequent calculations will even show how steady or variable a company’s financial dealings are. This information is important to creditors or banks for loans or investments.