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What is the 'Accounting Equation'

The accounting equation, also known as the balance sheet equation, is Assets = Liabilities + Equity and underpins the balance sheet's foundation. The accounting equation is the foundation of double-entry accounting, and displays that all assets are financed by borrowing money or paying with the money of the company's shareholders. 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, or said differently, all uses of capital (assets) are equal to all sources capital (debt: liabilities and equity: shareholders' equity).

BREAKING DOWN 'Accounting Equation'

Some people refer to the accounting equation as the "basic accounting equation" or balance sheet equation. One could also write it as Shareholders' Equity = Assets – Liabilities where the rearrangement reflects the residual claim of equity owners. Alternatively, one can rearrange the accounting statement, and the results of the equation will still hold if done properly. Thus, one can write the accounting equation multiple ways to reflect particular relationships, such as:

Shareholders' Equity = Assets – Liabilities

The above equation best reflects the equity owners' residual claim on total assets after subtracting all liabilities.

or

Assets = Shareholders' Equity + Liabilities

The above equation is the most commonly used form of the accounting equation and represents the claims on assets from debt and equity holders.

There is also an expanded accounting equation that further divides the three main financial statement accounts and is used for even deeper balance sheet analysis.

Assets and Total Liabilities in the Accounting Equation

The basic equation shows that a company can fund an investment with assets (a $50 purchase of equipment using $50 of cash), liabilities, shareholders' equity or both such as a $50 purchase of equipment by borrowing $50 or using $50 of retained earnings from the shareholders' equity account. In the same vein, companies can pay liabilities down with assets, like cash, or by taking on more liabilities, such as debt.

The total liabilities indicate the amount of money a company owes to its short-term and long-term creditors, and are divided into short-term liabilities, also known as current liabilities, and long-term liabilities. Companies expect to pay off short-term liabilities within one year, while they expect to pay off long-term liabilities more than one year from the balance sheet recording date.

Shareholders' Equity

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. One can write the equation as: Share Capital + Retained Earnings - Amount in Treasury Shares.

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