Before learning what an accounting equation is you must know what accounting means and what its purpose is. Accounting is the study of financial transactions. It includes summarizing the information, analyzing it, interpreting it and then reporting it.
Accounting is used everywhere. From a small shop in your area to a big multinational company, anywhere transactions are recorded and commercial work in the form of accounting. Accounting is of various types:
Cost accounting or managerial accounting
Transactions are recorded, and then the information gets interpreted and converted into financial statements. Financial statements include income statements and owner’s equity statement.
The balance sheet of a company contains an accounting equation. The equation is basic, yet it summarizes all the accounts information of the firm or business. The equation is
Total assets = total liabilities + total equity
It shows that the assets are equal to the sum of liabilities of a company and the total equity.
The balance sheet can be written down in any way you want. For example, the difference between the assets and the equity equals the liabilities. Total liabilities= total assets – total equity.
It can be written in another way around like Total equity = Total assets – total liabilities. It shows that if we subtract total liabilities from the total assets, we will return with the total equity generated.
Anything that a company or an organization owns is called an asset. They have full right to it, and it can’t be taken away from it.it includes things like property, equipment, cash accounts, account receivables, prepaid amounts, insurance, land, inventory, buildings, and goodwill.
The word liability means responsibility. Owning or running a business isn’t that easy. It looks quite attractive, but it has to be done by taking some responsibilities. The amount that the company owes is called its liability. The liability must be fulfilled at the particular time. The liabilities are further classified into two broad categories
The liabilities which are not that high and which have to be returned early. They are the loans taken by the company that has to be returned at a particular time. They are expected to be paid within one to two year time.
The liabilities which are high and the returning time limit is more. They are assumed to be paid after one year.
Capital and equity are slightly different. The amount invested in the business is its capital while the share of the assets is called equity. Equity can be of many types. If there is a single owner, then the capital will be called owner’s equity.
But if the shares of the company are sold then the investment will be put as shareholder’s equity. It is equal to the amount of capital generated after the liabilities are deducted from overall assets.
Owner’s equity = capital contributed + retained earning
Retained earnings = net income – the dividends
Use of accounting equation:
After the financial statements (which includes income statement and owner’s equity statement), a balance sheet is generated. It includes all assets, liabilities, & equity. If according to the equation assets equals the sum of liabilities plus equity, financial transactions which are done are correct, but if the equation doesn’t get balanced, it means there is some error. Accounting sheet helps to summarize and check the result of the transactions.
Let’s for example, there is a company, and it is generating its final balance sheet. Total assets equal to 56$ and liabilities including long and short equal to 25$. The shareholder’s equity is equal to 31$. If we check the balance by using an accounting equation
Assets= Liabilities + shareholder’s equity
Liabilities + shareholder’s equity = 25 + 31 = 56$ which is equal to the assets.
The equation is thus balanced.