What Is the Accounting Equation?
The accounting equation states that a company's total assets are equal to the sum of its liabilities and its shareholders' equity.
This straightforward relationship between assets, liabilities, and equity is considered to be the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the debit side has a corresponding entry (or coverage) on the credit side.
The accounting equation is also called the basic accounting equation or the balance sheet equation.
- The accounting equation is considered to be the foundation of the double-entry accounting system.
- The accounting equation shows on a company's balance that a company's total assets are equal to the sum of the company's liabilities and shareholders' equity.
- Assets represent the valuable resources controlled by the company. The liabilities represent their obligations.
- Both liabilities and shareholders' equity represent how the assets of a company are financed.
- Financing through debt shows as a liability, while financing through issuing equity shares appears in shareholders' equity.
Understanding the Accounting Equation
The financial position of any business, large or small, is based on two key components of the balance sheet: assets and liabilities. Owners’ equity, or shareholders' equity, is the third section of the balance sheet.
The accounting equation is a representation of how these three important components are associated with each other.
Assets represent the valuable resources controlled by the company, while liabilities represent its obligations. Both liabilities and shareholders' equity represent how the assets of a company are financed. If it's financed through debt, it'll show as a liability, but if it's financed through issuing equity shares to investors, it'll show in shareholders' equity.
The accounting equation helps to assess whether the business transactions carried out by the company are being accurately reflected in its books and accounts. Below are examples of items listed on the balance sheet.
Assets include cash and cash equivalents or liquid assets, which may include Treasury bills and certificates of deposit.
Accounts receivables list the amounts of money owed to the company by its customers for the sale of its products. Inventory is also considered an asset.
The major and often largest value asset of most companies be that company's machinery, buildings, and property. These are fixed assets that are usually held for many years.
Liabilities are debts that a company owes and costs that it needs to pay in order to keep the company running.
Debt is a liability, whether it is a long-term loan or a bill that is due to be paid.
Costs include rent, taxes, utilities, salaries, wages, and dividends payable.
The shareholders' equity number is a company's total assets minus its total liabilities.
It can be defined as the total number of dollars that a company would have left if it liquidated all of its assets and paid off all of its liabilities. This would then be distributed to the shareholders.
Retained earnings are part of shareholders' equity. This number is the sum of total earnings that were not paid to shareholders as dividends.
Think of retained earnings as savings, since it represents the total profits that have been saved and put aside (or "retained") for future use.
Accounting Equation Formula and Calculation
The balance sheet holds the elements that contribute to the accounting equation:
- Locate the company's total assets on the balance sheet for the period.
- Total all liabilities, which should be a separate listing on the balance sheet.
- Locate total shareholder's equity and add the number to total liabilities.
- Total assets will equal the sum of liabilities and total equity.
As an example, say the leading retailer XYZ Corporation reported the following on its balance sheet for its latest full fiscal year:
- Total assets: $170 billion
- Total liabilities: $120 billion
- Total shareholders' equity: $50 billion
If we calculate the right-hand side of the accounting equation (equity + liabilities), we arrive at ($50 billion + $120 billion) = $170 billion, which matches the value of the assets reported by the company.
About the Double-Entry System
The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet.
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 business transaction will be represented in at least two of its accounts. For instance, if a business takes a loan from a bank, the borrowed money will be reflected in its balance sheet as both an increase in the company's assets and an increase in its loan liability.
If a business buys raw materials and pays in cash, it will result in an increase in the company's inventory (an 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.
The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left side value of the equation will always match the right side value.
In other words, the total amount of all assets will always equal the sum of liabilities and shareholders' equity.
The global adherence to the double-entry accounting system makes the account keeping and tallying processes more standardized and more fool-proof.
The accounting equation ensures that all entries in the books and records are vetted, and a verifiable relationship exists between each liability (or expense) and its corresponding source; or between each item of income (or asset) and its source.
Limits of the Accounting Equation
Although the balance sheet always balances out, the accounting equation can't tell investors how well a company is performing. Investors must interpret the numbers and decide for themselves whether the company has too many or too few liabilities, not enough assets, or perhaps too many assets, or whether its financing is sufficient to ensure its long-term growth.
Below is a portion of Exxon Mobil Corporation's (XOM) balance sheet in millions as of Dec. 31, 2019:
- Total assets were $362,597
- Total liabilities were $163,659
- Total equity was $198,938
The accounting equation is calculated as follows:
- Accounting equation = $163,659 (total liabilities) + $198,938 (equity) equals $362,597, (which equals the total assets for the period)
Why Is the Accounting Equation Important?
The accounting equation captures the relationship between the three components of a balance sheet: assets, liabilities, and equity. All else being equal, a company’s equity will increase when its assets increase, and vice-versa. Adding liabilities will decrease equity while reducing liabilities—such as by paying off debt—will increase equity. These basic concepts are essential to modern accounting methods.
What Are the 3 Elements of the Accounting Equation?
The three elements of the accounting equation are assets, liabilities, and shareholders' equity. The formula is straightforward: A company's total assets are equal to its liabilities plus its shareholders' equity. The double-entry bookkeeping system, which has been adopted globally, is designed to accurately reflect a company's total assets.
What Is an Asset in the Accounting Equation?
An asset is anything with economic value that a company controls that can be used to benefit the business now or in the future. They include fixed assets such as machinery and buildings. They may include financial assets, such as investments in stocks and bonds. They also may be intangible assets like patents, trademarks, and goodwill.
What Is a Liability in the Accounting Equation?
A company's liabilities include every debt it has incurred. These may include loans, accounts payable, mortgages, deferred revenues, bond issues, warranties, and accrued expenses.
What Is Shareholders' Equity in the Accounting Equation?
Shareholders' equity is the total value of the company expressed in dollars. Put another way, it is the amount that would remain if the company liquidated all of its assets and paid off all of its debts. The remainder is the shareholders' equity, which would be returned to them.