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What is the 'Accounting Equation'

The accounting equation, also known as the balance sheet equation, is written as 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 either 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'

The accounting equation is sometimes referred to as the "basic accounting equation" or balance sheet equation could also be written as Shareholders' Equity = Assets – Liabilities, where the statement is rearranged to reflect 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, the accounting equation can be written in 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, liabilities can be paid 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. 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.

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. The equation could be written as: Share Capital + Retained Earnings - Amount in Treasury Shares.

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