What is an accounting equation?
The accounting equation – also known as the balance sheet equation indicates the relationship between the company’s assets, liabilities, and equity. According to the accounting equation, assets equal liabilities plus equity. This means that the company’s assets have been purchased with equity or liabilities.
The accounting equation is the foundation of double-entry accounting, a bookkeeping system in which every financial transaction is recorded in at least two different accounts in an equal and opposite manner. Entries made on the debit side are also made on the credit side to make sure that the balance sheet remains balanced.
The accounting equation makes sure that the company’s transactions are accurately recorded in the books. By understanding the accounting equation, accountants can identify and correct any errors in the company’s financial records.
Components of the accounting equation
There are three components to the accounting equation – assets, liabilities, and shareholders’ equity.
Assets: Assets are resources owned by the company that have use value. Examples include cash, cash equivalents, treasury bills, certificates of deposit, accounts receivable, and inventory.
Liabilities: Any debts and costs that the company has to pay back or anything that the company owes to someone are called liabilities. They include accounts payable, loans, bills, rent, taxes, wages, mortgages, bonds, and accrued expenses. Adding liabilities reduces equity and vice versa.
Shareholders’ Equity: Shareholders’ equity is the amount that remains if the company were to liquidate all its assets and pay off all its liabilities. This amount is then distributed among shareholders.
The accounting equation is helpful in that it keeps the balance sheet on track. But, it does not indicate the company’s performance to investors. Investors may have to look at the three components in detail to decide whether the company has too many or too few assets and liabilities.
