What Is the Accounting Equation?
The accounting equation is considered to be the foundation of the double-entry accounting system. On a company's balance sheet, it shows that a company's total assets are equal to the sum of the company's liabilities and shareholders' equity.
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.
- 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 assessed 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. The accounting equation is also called the basic accounting equation or the balance sheet equation.
While assets represent the valuable resources controlled by the company, the 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, and 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 are the amount of money owed to the company by its customers for the sale of its product and service. Inventory is also considered an asset.
Liabilities are what a company typically owes or needs to pay to keep the company running. Debt, including long-term debt, is a liability, as are rent, taxes, utilities, salaries, wages, and dividends payable.
Shareholders' equity is a company's total assets minus its total liabilities. Shareholders' equity represents the amount of money that would be returned to shareholders if all of the assets were liquidated and all of the company's debt was paid off.
Retained earnings are part of shareholders' equity and are equal to the percentage of net earnings that were not paid to shareholders as dividends. Think of retained earnings as savings since it represents a cumulative total of profits that have been saved and put aside or retained for future use.
Accounting Equation Formula and Calculation
The balance sheet holds the basis of 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, let's say for the fiscal year, leading retailer XYZ Corporation reported the following on its balance sheet:
- 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.
The Double-Entry System
The accounting equation forms the foundation of double-entry accounting and is a concise representation of a concept that expands into the complex, expanded, and multi-item display of a balance sheet. The balance sheet is based on the double-entry accounting system where the total assets of a company are equal to the total 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 two of its 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 an 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.
The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left side value of the equation will always match with 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 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 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 doesn't provide investors as to how well a company is performing. Instead, 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 is financing the company properly to ensure long term growth.
Real World Example
Below is a portion of Exxon Mobil Corporation's (XOM) balance sheet in millions as of Dec. 31, 2019:
- Total assets were $362,597 (highlighted in green).
- Total liabilities were $163,659 (first highlighted red area).
- Total equity was $198,938 (second highlighted red area).
The accounting equation whereby assets = liabilities + shareholders' equity is calculated as follows:
- Accounting equation = $163,659 (total liabilities) + $198,938 (equity) equals $362,597, (which equals the total assets for the period)