Accounting Equation Explained – Definition & Examples (2023)

Though Coca-Cola and your local fitness center may be as different as chalk and cheese, they do have one thing in common — and that's their ownaccounting equation.

The accounting equation is the basis ofdouble entry bookkeepingThis is the accounting method used by most businesses, regardless of their size, type or structure. This accounting method ensures that thebalance sheetStatement is always the same in the end.

We'll explain what that means, along with everything else you need to know about the balance sheet equation, as we move on.

In this guide you will learn:

• What is the billing equation?
• What are the three elements in the formula of the accounting equation?
• What is the double-entry bookkeeping method?
• 5+ Examples of Accounting Equations
• What are the limitations of the accounting equation

What is the billing equation?

The finances of any business consist of two basic elements: what it owns and what it owes.

financial assetsare the total resources owned by a company.ThatEquity capitalis the interest that the owner has in these assets, e.g. B. Personal investments or subscriptions.liabilities, on the other hand, show how much money is owed.

The relationship between these three financial components is expressed bythe balance sheet equation,As shown below:

As mentioned earlier, the accounting equation is the same for all companies. It is extremely important for businesses as it provides the basis for calculating various costsfinancial circumstances, as well as for creatingfinancial statements.

Before we delve into how the balance sheet equation helps eliminate double-entry bookkeeping, let's explain each element of the equation in detail.

What are the three elements in the formula of the accounting equation?

financial assets

financial assetsrepresent your company's ability to provide goods and services. Or in other words, it includes all valuables used to carry out activities such as production and sales.

We divide assets into two main categories:short term and long term.

Current assets are expected to be consumed within a year. They include:

• Cash and cash equivalents
• To invent
• accounts obtainable
• Prepaid Expenses

Non-current Assets extend their use for a period of one year. They can be either tangible (physical) or intangible.

tangible assets areBuildings, land and equipment.Intangibles consist ofpatents, trademarks or copyrights.

liabilities

Liabilities (or Commitments)are assets owed to creditors. Creditors include people or organizations to whom the company owes money, e.g. B. Employees, government agencies, banks and more.

We classify liabilities the same way as assets, based on current or long-term periods.

Current or short-term liabilities areemployeePayroll,bills, supply and utility costs.coverage of long-term liabilitiesLoans, mortgages and deferred taxes.

Equity capital

The owner's equityis the value of assets owned by the owner(s). More specifically, it is the amount left over when assets are liquidated and liabilities are paid off.

Let's look at what causes the increases and decreases in owner's equity.

• increase in equity- Two main sources cause an increase in equity:Investments of the owner and income. investmentsare the money that the owner personally invests in his business. These investments are recorded under a category called owner capital.revenues,on the other hand, represent profits made from business activities such as sales, fees, renting a property, lending cash, commissions and more.
• Decrease in equity -Reductions in equity result from drawings and expenses.Drawings are theCash withdrawn by the ownerfrom business accounts. WhileCostare the costs incurred by consumed assets. For example equipment purchase, labor costs, ancillary costs, taxes,etc.

Extended version of the calculation equation

Well there isextended version of the balancing equationwhich includes all of the elements (described in the section above) that make up equity.

It looks like this:

This wording gives you a full visual representation of the relationship between the company's main accounts.

However, this is not the only type of reorganization you can make to the accounting equation. It can be transformed and interpreted into two other forms:

1.Equity = Assets - Liabilities

At first glance, you probably won't see much of a difference from the basic accounting equation. However, when the owner's equity is shifted to the left, the equation takes on a different meaning.

It tells us that creditors have priority over owners when it comes to getting their claims paid. While the main objective of the basic accounting equation is to present the financial position of the company.

2.Net Worth = Assets - Liabilities

This is another form of the equation that you may come across. It's essentially the same equation because net worth and equity are synonymous. Other equity names you may come across are also net worth or equity (for public corporations).

What is the double-entry bookkeeping method?

Every business transaction has a double effect on the accounting. For example, when an asset goes up, there is always a corresponding one:

• Decrease of another asset
• increase in a liability
• increase in equity.

Now these changes in the accounting equation are recorded in the company's financial booksdouble entry bookkeeping.

Double-entry bookkeeping is a system in which transactions and their effects are recordedjournal entries, throughdeductan account andcredit amountAnother.

Direct debits are cash going into the business, while loans are cash going out.

An equivalent credit entry must be made for each debit entry. Debits and credits should always balance out in the end.

In order to understand which accounts are debited or credited when you exchange money, we have created a cheat sheet so that you can easily understand it.

Don't want to worry about double-entry bookkeeping for your small business? Useaccounting softwarelike Deskera to automate your company's accounting process!

Deskera integrates directly with your bank account and automatically posts every purchase and expense made to the correct ledger accounts with the appropriate debit and credit amounts. So you don't have to worry about anything!

And that's not even the best part.

With Deskera you can automate other parts of theaccounting cyclealso, like the management of stocks,send invoices, payroll accounting and much more.

Deskera Booksis a time-saving strategy for managing your work contacts, billing, bills and expenses. You can also import opening balances and set up chart accounts with them.

Deskera Books is aOnline accounting softwarewhich enables you to generate e-invoices for compliance. You can easily create e-invoices by clicking the create e-invoice button.

A short video tour will help you better understand the whole process in a few minutes.

Now that you have Deskera you can easily manage yoursmagazines. A single interface gives you access to all its notable features, including the ability to add products, services, and inventory.

With this accounting software you can create and send invoices automatically. In addition, the preparation of financial statements has become significantly easier thanks to the software that allows you to draft thembalance sheets,income statement,Profit and Loss Accounts andcash flowTestify.

From setting up your organization to inviting your colleagues and your accountant, you can achieve it all with Deskera Books. You can witness the easy implementation of the tool and try it out to gain new experience in dealing with your accounting system.

Get acquainted with a new system that handles accounting, finance, inventory and much more under one roof.

The balance

The balance sheet is a more detailed reflection of the accounting equation. It records the assets, liabilities and equity of a company at a given point in time. Just like the balance sheet equation, it tells us that total assets equal total liabilities and equity.

The preparation of the balance sheet is one of the last steps in the accounting cycle and is carried out using double-entry bookkeeping.

In order to prepare the balance sheet and other financial statements, you must first decide on onebilling system. The three main systems used in economics are manual,cloud-based accounting softwareand ERP software.

5+ Examples of Accounting Equations

To better understand the balance sheet equation, let's take a few practical transactions and analyze their effect.

Suppose the following examples are transactions for company XYZ during their first month of work:

1.The business owner invests $10,000 in Company XYZ.This transaction will result in an increase in the owner's cash and equity of $10,000. The equation would look like this:

2.Company XYZ buys $3,000 worth of equipment.In this case, there is a $3,000 increase and decrease in wealth. The cash account goes down while the gear account goes up. This is what the entry in the equation would look like:

3.Company XYZ buys $1,300 worth of goods on credit.This transaction results in a $1,300 increase in both assets and liabilities from trade payables. Specifically, the accounts concerned are deliveries and payables. This third transaction would appear in the equation as follows:

4.XYZ receives $800 in cash from clients for services rendered.When receiving cash from services, the two accounts that increase by $800 are the cash and earnings accounts. The billing equation would look like this:

5.XYZ pays $400 for employee salaries.The effect of this payment is a $400 decrease in the cash and expense accounts. This transaction would look like this:

If we add both sides of the equation, they add up to $27.00 and balance out as shown below:

Want to learn more about transaction recording and bookkeeping for your small business? Read our ultimate guide on how to do thisSmall Business Accounting.

What are the limitations of the accounting equation

As helpful as the accounting equation is in accounting for your business, it has its own limitations.

First off, it doesn't provide investors or other interested third parties with an analysis of how well the business is doing.

In addition, it does not completely prevent accounting errors from being made. Even if the balance balances out, there is still the possibility of an error that does not affect the balance equation.

If you want to know more about accounting errors and how to recognize them, we recommend readingCommon accounting mistakes- A practical guide with examples.

The central theses

And that concludes our accounting equations guide! We hope you found it helpful.

To recap, here are some of the key points we covered:

• The accounting equation is the fundamental tool that enables double-entry bookkeeping for all businesses, regardless of their size or purpose. It represents the relationship between three main entities: assets, liabilities and equity.
• Assets are the business resources, such as B. Cash, inventory, buildings. Payables are liabilities to creditors such as bills, loans, taxes. Owner equity represents assets owned by the owner or shareholders.
• The balance equation can be rearranged in three different ways:
  • Assets = Liabilities + Owner's Equity - Owner's Subscriptions + Income - Expenses
  • Equity = Assets - Liabilities
  • Net Worth = Assets - Liabilities
• Changes in accounting are recorded in double-entry bookkeeping.
• The balance sheet is a financial statement that presents the accounting equation in more detail and expanded.
• The main limitation of the accounting equation is that it provides no analysis of how well the business is doing.

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