What is the 'Accounting Equation'
The equation that is the foundation of double entry accounting. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company's shareholders. Thus, the accounting equation is: Assets = Liabilities + Shareholder Equity. The balance sheet is a complex display of this equation, showing that the total assets of a company are equal to the total of liabilities and shareholder equity.
BREAKING DOWN 'Accounting Equation'Any purchase or sale by an accounting equity has an equal effect on both sides of the equation, or offsetting effects on the same side of the equation. The accounting equation could also be written as Liabilities = Assets – Shareholder Equity and Shareholder Equity = Assets – Liabilities.
The basic equation shows that a company can fund the purchase of an asset with assets (a $50 purchase of equipment using $50 of cash) or fund it with liabilities or shareholder equity (a $50 purchase of equipment by borrowing $50 or using $50 of retained earnings). In the same vein, liabilities can be paid down with assets, like cash, or by taking on more liabilities, like debt.
The total liabilities indicate the amount of money a company owes to its short-term and long-term creditors. The total liabilities are divided into short-term liabilities, also known as current liabilities, and long-term liabilities. Short-term liabilities are expected to be paid off within one year, while long-term liabilities include debts that are expected to be paid off over one year from the balance sheet recording date. For example, assume a hypothetical company has total current liabilities of $5 million and total long-term liabilities of $20 million. Therefore, the company has total liabilities of $25 million, or $5 million + $20 million.
The shareholders' equity portion of the accounting equation could be calculated by summing the amount of share capital and retained earnings and subtracting the amount in treasury shares from the sum. The equation could be written as: Share Capital + Retained Earnings - Amount in Treasury Shares. For example, assume hypothetical company Rocket has share capital of $10 million, retained earnings of $25 million and treasury shares worth $5 million. Therefore, Rocket has total shareholders' equity of $30 million, or $10 million + $25 million - $5 million.
Real World Example
For example, Apple Inc. reported its annual balance sheet in September 2015. Apple had total current liabilities of $80.61 billion and total long-term liabilities of $90.51 billion. Therefore, it had total liabilities of $171.12 billion, or $80.61 billion + $90.51 billion. Apple had total common stock worth $27.42 billion, retained earnings of $92.28 billion and other stock holder equity of -$345 million. Therefore, it had total shareholders' equity of $119.36 billion, or $27.42 billion + $92.28 billion - $345 million. Consequently, it had total assets of $290.48 billion, or $171.12 billion + $119.36 billion.