The fundamental accounting equation represents the relationship between the assets, liabilities, and the owner's equity of an investor in the company. The equation is also known as the balance sheet equation this is because it helps in keeping the balance of both the sides of balance sheet equal. It is also the foundation for the double-entry bookkeeping system. For each transaction that takes place in the business, the balance of total debits is equal to the balance of total credits. It can be understood as follows:
A = L + E
In a company, capital represents the stockholders' equity. As we know, every business transaction has its effect on at least two accounts of the company; the accounting equation is always being "in balance". Thus, the accounting equation presents what the company owns (assets) and what it owes (liabilities) to others by what its owners invest (shareholders' equity or capital).
The above-given formula can be rewritten as:
Assets - Liabilities = Shareholders' Equity
This means the shareholders' equity is the difference between assets and liabilities. The calculation of Shareholders' or Owner's Equity can be done by using the following formula:
Owner's Equity = Contributed Capital + Retained Earnings …(1)
Retained Earnings = Net Income + Dividends …(2)
Net Income = Revenue - Expenses …(3)
The accounting equation is formed by using all these substitutes which makes it an expanded accounting equation as it represents the breakdown of the equity component of the accounting equation. So, by putting the value of (1), (2), and (3) equations in the equation given in the figure, we got the following new equation:
Assets = Liabilities + Contributed Capital + Revenue - Expenses - Dividends
Other Formulas used in Accounting Equation
Some other formulas that are used to calculate the accounting equation are as follows:
1. Total Assets
Assets have two types which are added to calculate the total balance of assets. It can be understood as follows:
Total Assets = Current Assets + Non-Current Assets
2. Total Liabilities
Similarly, liabilities also have two types which are added to calculate the total balance of liabilities. It can be clear from the given formula:
Total Liabilities = Current Liabilities + Non-current Liabilities
Applications of Accounting Equation
The various applications of accounting equations in accountancy and economics are as follows:
- Financial Statement
The financial statements or the company's quarterly and annual reports that show its financial performance are derived directly by using the accounting equation during the bookkeeping practices. The ledger of the business is prepared with the help of an accounting equation which further provides the material to prepare various financial statements of the company. This material includes expense reports, cash flow and salary, and company investment.
- Double Entry Bookkeeping System
The accounting equation is a very important aspect of the double-entry bookkeeping accounting system also and works as its foundation. The main aim of the system of double-entry is to make a balanced record of debit and credit and make sure that their sum is always equal to the company's assets. This can be done by applying the accounting equation while recording the balances. It is based on the idea that each transaction has an equal effect on the balances of both sides, i.e., debit and credit. Hence, every transaction in the business is recorded twice in the books of accounts to keep the balance equal. The equation is used to transfer the totals from books of prime entry into the nominal ledger.
- Income and Retained Earnings
The income and retained earnings are also important components in computing, understanding, and analyzing the company's income statements. This statement shows the records of the company's profits and losses which are calculated by using the basic accounting equation. In other terms, this equation helps the firms in calculating or determining a company's revenue and also preparing its statement of retained earnings. This all is beneficial for the business to predict the future trend of profit or loss and adjust the business practices accordingly to deal with the situation. In short, the accounting equation plays a vital role in determining the profitability of the company.
- Company Worth
As we know, the balance sheet of a company is prepared by using the principles of the accounting equation; this equation is also responsible for estimating the net worth of the entire business. The accounting equation works on the fundamental components of calculating both the company's holdings and its debts. Thus, it helps the accountant or the financial manager figure out the total value of the firm's assets.
However, the accounting works on a historical basis, the equity is not included while calculating the net worth of the business. Another point to be noted here is that the capital assets are recorded on a value that is less than their real value or the value in the secondary market. This is because of the concept of depreciation that continuously reduces the value of the assets whether it is used or not.
The accounting equation is also highly valuable for the investors. As it helps in determining the net worth or the financial position of the business, the investors can make rational decisions to invest their funds. To make this decision, the investors can look to measure the company's holdings and debts at any particular time. The frequent calculations of this data can show how steady or erratic a business' financial dealings might be. This information is not only valuable for the investors but also for the other parties who might be considering a loan application to the firm.