What is the Accounting Equation
The accounting equation is considered to be the foundation of the double-entry accounting system. The total of all the assets of a business should be equal to the total of all its liabilities in the balance sheet. Based on this double-entry system, the accounting equation ensures that the balance sheet remains “balanced,” and each entry made on the debit side should have a corresponding entry (or coverage) on the credit side.
BREAKING DOWN Accounting Equation
The financial position of any business, large or small, is assessed based on the two key components – assets and liabilities. Business owners’ equity or shareholders' equity, which is calculated as the difference between assets and liabilities, is another common measure that represents the financial standing of a business. Also called as the basic accounting equation or the balance sheet equation, the accounting equation is a simple representation of how these three important components amounts are associated with each other.
While assets represent the valuable resources owned by the company, the liabilities represent its obligations. The accounting equation helps to assess whether the business transactions carried on by the company are being accurately reflected in its books and accounts.
Formula of Accounting Equation
The formula for accounting equation is derived on the basic premise that the equity owners have a residual claim on the total assets of a company after subtracting all the liabilities owed by the company. This is represented by the equation:
Shareholders' Equity = Assets – Liabilities
When rearranged, the above equation gives,
Assets = Shareholders' Equity + Liabilities
The above equation is the most commonly used form of the accounting equation and represents the claims on assets by the debt and equity holders.
Additionally, an expanded form of accounting equation also exists which further expands the equity component of the formula into three main financial statement accounts. Called the expanded accounting equation, it is used for a deeper analysis of the balance sheet and is represented by:
Assets = Contributed Capital + Beginning Retained Earnings + Revenue - Expenses – Dividends + Liabilities
Double-entry Accounting System
The accounting equation forms the foundation of the double-entry accounting, and is a concise representation of a concept that expands into the complex, expanded and multi-item display of balance sheet. The balance sheet is based on the double-entry accounting system where total assets of a company are equal to the total of liabilities and shareholder equity. 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 single business transaction will be represented in at least of its two accounts. For instance, if a business takes a loan from a financial entity like a bank, the borrowed money will raise the company's assets and the loan liability will also rise by an equivalent amount. If a business buys raw material by paying cash, it will lead to increase in the inventory (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. This practice ensures that the accounting equation always remains balanced – that is, the left side value of the equation will always match with the right side value.
Accounting Equation Calculation Example
For the fiscal year ending January 2018, leading retailer Walmart Inc. (WMT) reported total assets worth $204.52 billion, total liabilities worth $123.7 billion and total equity worth $80.82 billion. The equity comprised of shareholders’ equity worth $77.87 billion and accumulated minority interest worth $2.95 billion.
Computing the right hand side of the accounting equation (Equity + Liabilities) gives ($80.82 + $123.7) = $123.7 billion, which matches the value of the assets reported by the company.
Leading technology giant Microsoft Corp. (MSFT) reported assets worth $258.85 billion, liabilities worth 176.13 billion and equity worth $82.72 billion for the fiscal year ending June 2018. Result obtained by summing up the latter two figures matches the reported asset value, which indicates that the accounting equation is balanced and each business transaction is appearing in the books and records of the company.
The Bottom Line
The global adherence to the double-entry book-entry accounting system makes the account keeping and tallying processes much easier, standardized and fool-proof to a good extent. The accounting equation ensures that all entries in the books and records are vetted, and a verifiable relationship exist between each liability (or expense) and its corresponding source, or between each item of income (or asset) and its source.