The
accounting equation states that a company's total assets are equal to the sum
of its liabilities and its shareholders' equity.
This
straightforward relationship between assets, liabilities, and equity is
considered to be the foundation of the double-entry accounting system.
The accounting equation ensures that the balance sheet remains balanced. That
is, each entry made on the debit side has a corresponding entry (or coverage)
on the credit side.
The
accounting equation is also called the basic accounting equation or the balance
sheet equation.
Understanding
the Accounting Equation
The
financial position of any business, large
or small, is based on two key components of the balance sheet assets and
liabilities. Owners’ equity, or shareholders' equity, is the third section of
the balance sheet.
The
accounting equation is a representation of how these three important components
are associated with each other.
Assets
represent the valuable resources controlled by the company, while liabilities
represent its obligations. Both liabilities and shareholders' equity represent
how the assets of a company are financed. If it's financed through debt, it'll
show as a liability, but if it's financed through issuing equity shares
to investors, it'll show in shareholders' equity.
The accounting equation helps to assess whether the business transactions carried out by the company are being accurately reflected in its books and accounts. Below are examples of items listed on the balance sheet.
Assets
Assets
include cash and cash equivalents or liquid assets, which may
include Treasury bills and certificates of deposit.
Accounts
receivables list the amounts of money owed to the company by its customers
for the sale of its products. Inventory is also considered an asset.
The major
and often largest value asset of most companies be that company's machinery,
buildings, and property. These are fixed assets that are usually held for many
years.
Liabilities
Liabilities
are debts that a company owes and costs that it needs to pay in order to keep
the company running.
Debt is a
liability, whether it is a long-term loan or a bill that is due to be paid.
Costs
include rent, taxes, utilities, salaries, wages, and dividends payable.
Shareholders' Equity
The
shareholders' equity number is a company's total assets minus its total
liabilities.
It can be
defined as the total number of dollars that a company would have left if it
liquidated all of its assets and paid off all of its liabilities. This would
then be distributed to the shareholders.
Retained
earnings are part of shareholders' equity. This number is the sum of
total earnings that were not paid to shareholders as dividends.
Think of
retained earnings as savings, since it represents the total profits that have
been saved and put aside (or "retained") for future use.
Accounting Equation Formula and Calculation
Assets=(Liabilities+Owner’s Equity)
The
balance sheet holds the elements that contribute to the accounting equation:
1. Locate the company's total assets on the balance sheet
for the period.
2. Total all liabilities, which should be a separate listing
on the balance sheet.
3. Locate total shareholder's equity and add the number to
total liabilities.
4. Total assets will equal the sum of liabilities and total
equity.
As an
example, say the leading retailer XYZ Corporation reported the following on its
balance sheet for its latest full fiscal year:
- Total assets: $170
billion
- Total liabilities:
$120 billion
- Total shareholders'
equity: $50 billion
If we
calculate the right-hand side of the accounting equation (equity +
liabilities), we arrive at ($50 billion + $120 billion) = $170 billion, which
matches the value of the assets reported by the company.
About the Double-Entry System
The
accounting equation is a concise expression of the complex, expanded, and
multi-item display of a balance sheet.
Essentially,
the representation equates all uses of capital (assets) to all sources of
capital, where debt capital leads to liabilities and equity capital leads to
shareholders' equity.
For a
company keeping accurate accounts, every business transaction will be
represented in at least two of its accounts. For instance, if a business takes
a loan from a bank, the borrowed money will be reflected in its balance sheet
as both an increase in the company's assets and an increase in its loan
liability.
If a
business buys raw materials and pays in cash, it will result in an
increase in the company's inventory (an asset) while reducing cash
capital (another asset). Because there are two or more accounts affected by
every transaction carried out by a company, the accounting system is referred
to as double-entry accounting.
The
double-entry practice ensures that the accounting equation always remains
balanced, meaning that the left side value of the equation will always match
the right side value.
In other
words, the total amount of all assets will always equal the sum of liabilities
and shareholders' equity.
The global
adherence to the double-entry accounting system makes the account keeping and
tallying processes more standardized and more fool-proof.
The
accounting equation ensures that all entries in the books and records are
vetted, and a verifiable relationship exists between each liability (or
expense) and its corresponding source; or between each item of income (or
asset) and its source.
Limits of the Accounting Equation
Although
the balance sheet always balances out, the accounting equation can't tell
investors how well a company is performing. Investors must interpret the
numbers and decide for themselves whether the company has too many or too few
liabilities, not enough assets, or perhaps too many assets, or whether its
financing is sufficient to ensure its long-term growth.
Real-World Example
Below is a
portion of Exxon Mobil Corporation's (XOM) balance sheet in
millions as of Dec. 31, 2019:
- Total assets were
$362,597
- Total liabilities
were $163,659
- Total equity was
$198,9381
The
accounting equation is calculated as follows:
- Accounting equation = $163,659
(total liabilities) + $198,938 (equity) equals $362,597, (which equals the
total assets for the period)
Why Is the Accounting
Equation Important?
The accounting equation captures the
relationship between the three components of a balance sheet: assets,
liabilities, and equity. All else being equal, a company’s equity will increase
when its assets increase, and vice-versa. Adding liabilities will decrease
equity while reducing liabilities—such as by paying off debt—will increase
equity. These basic concepts are essential to modern accounting methods.
What Are the 3
Elements of the Accounting Equation?
The three elements of the accounting
equation are assets, liabilities, and shareholders' equity. The formula is
straightforward: A company's total assets are equal to its liabilities plus its
shareholders' equity. The double-entry bookkeeping system, which has been
adopted globally, is designed to accurately reflect a company's total assets.
What Is an Asset in the
Accounting Equation?
An asset is anything with
economic value that a company controls that can be used to benefit the business
now or in the future. They include fixed assets such as machinery and
buildings. They may include financial assets, such as investments in stocks and
bonds. They also may be intangible assets like patents, trademarks, and goodwill.
What Is a Liability in
the Accounting Equation?
A company's liabilities include
every debt it has incurred. These may include loans, accounts payable,
mortgages, deferred revenues, bond issues, warranties, and accrued expenses.
Shareholders' equity is the total
value of the company expressed in dollars. Put another way, it is the amount
that would remain if the company liquidated all of its assets and paid off all
of its debts. The remainder is the shareholders' equity, which would be
returned to them.
