What is Accounting Equation ?
Accounting Equation is the basis for recording business transactions in books of accounts.
Assets = Liabilities + Capital
A business’s assets are financed by either the owner or third parties. This equation represents the equality of assets, liabilities, and capital between owners and outsiders. An Accounting Equation is a mathematical statement that indicates a firm’s assets and liabilities are equal. In mathematical form.
The accounting equation is a basic principle in modern accounting that states that a company’s assets are the sum of its liabilities and shareholder equity.
The accounting equation illustrates the core features of the double-entry accounting system. Under this system, debit is always equal to credit, and assets are always equal to the sum of equity and liabilities. An accounting equation is basically a relationship between assets, liabilities, and the owner’s ownership in the business.
Key Points of Accounting Equation
- The accounting equation is regarded to be the basis of the double-entry accounting system.
- It indicates on a company’s balance sheet that its total assets equal the sum of its liabilities and shareholders’ equity.
- Assets represent a company’s valuable resources, while liabilities represent its commitments.
- Liabilities and shareholder equity demonstrate how a company’s assets are financed.
- Financing by debt is shown as a liability, while financing through the issuance of equity shares appears in shareholders’ equity.
Components of Accounting Equation
Assets
Assets are every thing a business possesses or controls that has value and may be utilized to pay off debts or produce revenue. This comprises cash, cash equivalents, certificates of deposit, treasury bills, and so on.
Patents and trademarks are examples of intangible assets owned by businesses. Essentially, these are resources that can aid a company’s growth and financial sustainability.
Liabilities
Liabilities are debtor responsibilities that a company owes to others,such as loans,mortgage ,or unpaid payments.
They are claims against a company’s assets and are critical in comprehending the future financial responsibilities that a company must meet.
Essentially, liabilities are tht a company must need to pay in order to function properly.
Owner’s equity
It indicates the owners claim to the business’s assets after all liabilities have been paid.
Owner’s equity is simply that, the business owner has after all obligations have been paid off.
Importance of Accounting concepts
- Accounting equation is important for money management, because it helps you to understand how well a business is performing financially.
- The accounting equation is an important tool for financial analysis, allowing businesses to make informed decisions. Using this equation, managers can assess their financial situation and decide whether to fund operations with debt or equity.
- The equation used to calculate financial ratios like the debt-to-equity ratio, which helps analyze a company’s risk and financial leverage.
- It help to determine company’s assets and liabilities and equity.
- Accounting equation is important for assessing a company’s liquidity.
Types of Basic Accounting Equation
The accounting equation, commonly known as the ‘Balance Sheet Equation’, serves as the foundation for all financial accounting. There are three types of basic accounting equation.
Equation:1
Assets = Liabilities + Owner’s equity
This balance sheet equation shows you that all the assets possessed by the business are either sponsored using the owners’ equity or the amount that the company should owe others such as suppliers or borrowings like loans.
Equation:2
Liabilities = Assets – Owner’s equity
This equations shows that,the difference between assets and the owner’s investment in the business is your liabilities, which include payables to suppliers, banks, and other third parties.
Equation:3
Owner’s equity = Assets – Liabilities
This equation calculates the value of assets owned solely by entirely While attempting to calculate this correlation, we can see that income or gains will raise the owner’s equity, while expenses or losses will decrease it.
Example of Accounting Equation
Example:1
A business man suraj Pawan Laxkar started a printing business.
- Suraj Pawan Laxkar invested Rs. 40,0000(indian rupees) to start a printing business.
- Company obtain loan from bank of Rs.600,000.
- Rendered services and received the full payment in cash Rs.10,000 Cash increased thereby increasing assets. Income increases capital.
- Rendered services on account receivable from customer Rs.15000.
- Purchased office supplies on account, payable to supplier Rs.4000.
- Equipment repair expenses Rs.8000
- Suraj withdraw 100,000. for personal reasons.
- Paid one third of loan obtained,Cash is decreased by Rs.2,00,000 as a result of payment. liabilities are decreased because parts of obligation has been settled.
Transaction | Assets | = | Liabilities | + | Capital |
1. Investment | 4,00,000 | = | + | 4,00,000 | |
2. Loan | 6,00,000 | = | 6,00,000 | + | |
3. services revenue for cash | 10,000 | = | + | 10,000 | |
4. Services revenue on account | 15,000 | = | + | 15,000 | |
5. Supplies on account | 4000 | = | 4,000 | + | |
6. Repair of equipment | = | 8,000 | + | -(8000) | |
7. Owners withdraw | 1,00,000 -(1,00,000) | = | + | -(1,00,000) | |
8. Payment of loan | 2,00,000 -(2,00,000) | = | -(2,00,000) | + | |
Balance | 7,29,000 | = | 4,12,000 | + | 3,17,000 |
Example:2
- Suresh kumar started a clothing business with investment of 20,000(indian rupees)
- Purchased goods on credit of Rs.2,000.
- Bought machinery for Rs.8,000 cash.
- Purchased goods for Rs. 4,000 cash.
- Sold goods for 6,000( cost of inventory 4000+ profit 2000)
- Paid salary of Rs.6,000.
- Paid wages of Rs.3,000.
Transaction | Assets | = | Liabilities | + | Capital |
Capital investment | 20,000 | = | + | 20,000 | |
Purchased goods on credit of 2000 | 2000 | = | 2,000 | + | |
Bought machinery for cash 8,000 | 8,000 -(8,000) | = | + | ||
Purchased goods for cash 4,000 | 4,000 -(4,000) | = | + | ||
Sold goods for cash 6,000(cost of inventory 4,000+profit 2,000) | 6,000 -(4,000) | = | + | 2,000 | |
Paid salary 6,000 | -(6000) | = | + | -(6,000) | |
paid wages | -(3,000) | = | + | -(3,000) | |
Balance | 15,000 | = | 2,000 | + | 13,000 |
Limitations of Accounting Equation
Does not Reflect Market Value
Accounting equation is based on book values rather than actual ones. It may not fully reflect the real time economic value of assets.
Lack of Operational Insights
It provides no information about the company’s operational efficiency or profitability. This equation does not include revenue or spending information.
No Risk Analysis
Accounting equation doesn’t account for the risk connected with the assets or obligation,such as bad beby or asset obsolescence.
FAQ
What is Balance Sheet ?
The balance sheet is an important financial document that reflects a company’s financial situation at a certain point in time. It depicts the relationship between a company’s assets, liabilities, and equity, providing an overall picture of its financial health.
What is the basic accounting equation formula?
The basic accounting equation formula is , Assets=Liabilities+Capital