The Accounting Equation: Explained

The foundation of most businesses is its grasp on certain accounting principles, such as keeping track of it profits gains and losses, as well as its assets and liabilities. Whether the structure of a business is a simple sole-proprietorship or a more complex corporation, certain accounting fundamentals need to be applied.  One of which that will be discussed in this post is the Accounting Equation and its purpose.

The Accounting Equation – is the equation that displays both sides of a business’s finances, which can define double entry accounting as well as it shows the balance of its assets, owner’s equity, and the businesses liabilities.  (Tracy, 2008, p. 343)

Below is the Accounting Equation in the three different forms it can be applied:

Assets = Owner’s Equity + Liabilities

Assets – Liabilities = Owner’s Equity

Owner’s equity + Liabilities = Assets

So how can the above equations be applied to a business’s financial statement?  Okay, so let us say the liabilities of a company equals to 3.5 million and the owner’s equity is 2.5 million, than the Assets would be 6 million.  Which than would look like this:

3.5 million (Liabilities) + 2.5 million (Owner’s Equity) = 6 million (Assets)

The above equation would be applied to the company’s balance sheet at the end of the accounting period as well as the accounting cycle.  A company’s balance sheet is prepared at the end of an accounting period and features a summarized calculation of the company’s assets, liabilities and the owner’s equity.  (Van Blokland & Knowles, 2008)

For example, we have a company whose name is Widget Inc and their accountant prepared a balance sheet for the end of 2008.  The company’s assets include cash of $5.4 million, an inventory of $10.2 million, property value of $2.3 million and equipment worth $3.6 million. Widget, Inc.’s liabilities add up to $3.5 million, their accounts payable is $4.2 million and their accrued expense payable equals to $6.2 million.  The owner’s equity is comprised of an invested capital of $2.5 million and $5.1 million of retained earnings for 2008.  This would mean that the total in assets would be $21.5 million and the collaborated amount of liabilities and owner’s equity would equal to the same; meaning the books are balanced out.  Please see the figure 1-1 below:

Above is an example of a balance sheet that has been calculated at the end of a financial period, how does the accountant figure out the numbers to populate the above sheet?  From the beginning of the previous financial period or at the beginning of the business entirely, all receipts, and documentation on any and every transaction is recorded into a journal and then is finalized by being posted to a ledger.  The way the transactions are recorded into the journals; usually there is more than one journal, each designated to a specific account.  For example, if we had three journals one for the company’s liabilities, one for the company’s assets as well as for the owner’s equity and Widgets, Inc. made a $2,500.00 payment for a shipment; at the same time they received a payment from a big account ($6,000.00).  The three journals would look like they do in Figure 2-1:

Figure 2-1 (Created by: Tiffany Aliano, 4/18/2009)

The above is also an example of double-entry accounting, which is when you document a transaction and its effects on the company’s finances, in the form of debits, and credits. (Tracy, 2008, p. 69)  Throughout the course of the financial period should zero out, meaning records of the businesses financial events were thoroughly maintained as far as to the standards of GAAP or Generally Accepted Accounting Principles. 

In conclusion, the accounting equation is a viable and fundamental tool to accounting practices, where when used to calculate expenses, and assets can give the company’s owner, owners, or executives the ability to keep track of the company’s as well as individual department’s finances.  In addition, come the end of the financial period and say if the books did not balance, the accountant, auditors as well as financial members of the company would be able to back track to the necessary transaction.  This could have easily been a data-entry mistake, or even reveal the source of fraud or any other king of money laundering taken place within the infinite levels of a company.

References

Tracy, J. A. (2008).  3: Bookkeeping and Accounting Systems.  In J. Friedman (Ed.), Accounting for Dummies (4th ed., p. 69).  Hoboken, NJ: Inc.-Wiley Publishing.

Tracy, J. A. (2008).  Glossary: Slashing through the accounting jargon jungle.  In J. Friedman (Ed.), Accounting for Dummies (4th ed., p. 343).  Hoboken, NJ: Inc.-Wiley Publishing.

Van Blokland, PJ, & Knowles, B. (2008).  A Beginner’s Guide to the Balance Sheet.  Retrieved April 18, 2009, from University of Florida Web site: http://edis.ifas.ufl.edu/FE153