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Business Financials – What is the Accounting Equation and an Example

images/Business Financials.JPGThe Accounting Equation is used in both small and large business, and gives a financial position or Balance Sheet of the business – ie its value (also known as equity), after debts/liabilities. The Accounting Equation or financial position is calculated from three items – assets (what it OWNS), liabilities (what is OWES) and equity (the difference between assets and liabilities, or owner’s NET WORTH).

The accounting equation is a simple way to understand how these three amounts relate to each other, and written -

Assets - Liabilities = Equity

The accounting equation is also reported another way (eg USA)

Assets = Liabilities + Owner’s Equity for a small business sole proprietor

The accounting equation for a company/corporation is:

Assets = Liabilities + Stockholders’ Equity

So let’s break down what each part is -

Assets are the company’s resources - what the company owns of value - cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner’s (or stockholders’) equity.

Liabilities are the company’s obligations - what the company owes - notes or loans payable, accounts payable, salaries and wages payable, interest payable, superannuation, and income and payroll taxes payable.

Owner’s equity or stockholders’ equity is the amount left over after liabilities are deducted from assets:

Assets – Liabilities = Owner’s (or Stockholders’) Equity. It also reports the amounts invested into the company by the owners plus the cumulative net profit/income of the company that has not been withdrawn or distributed to the owners.

With accurate records, the accounting equation will always be “in balance,” meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of the company’s accounts. As an example, if a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase (inventory) and one asset will decrease (bank paid for the stock). Because there are two or more accounts affected by every transaction, the accounting system is referred to as double entry accounting.

A company keeps track of all of its transactions by recording them in different accounts in the company’s general ledger. Each account in the general ledger is designated as to its type: asset, liability, owner’s equity, sales/revenue, expense, profit, or loss account.

Example - Accounting Equation

You start your business by loaning $10,000 to the business bank account

Put some tools $2,000 on credit, which you are liable to pay later

Sell $500 of services or items, is banked

(image attached)

               Accounting Equation

Assets

Bank                      $10,500

Tools/Equipment     $2,000

                                             $12,500

Liabilities

Creditor/Supplier     $2,000

                                               $2,000

Assets $12,500 - $2,000 = $10,500, which matches Equity as below -

Equity

               Owner Equity        $10,000

               Net Sales                   $500

                                                            $10,500

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