The accounting equation is the ratio of all the company assets to the sum of its liabilities and the shareholders’ equity. Although it is not a simple tool, it can be considered quite useful for understanding the economic evolution of a company.
The accounting equation refers to the formula that determines that the sum of all the company’s assets equals the sum of all liabilities plus shareholders’ equity.
It is important to note that the direct relationship between assets, equity, and liabilities would be what is valued in the double-entry accounting system. Through this formula, we can find out what the internal balance sheet of the company is like and whether it is balanced.
This balance has to do with the fact that every time we make an entry on the debit side of the company, there must be coverage or access on the credit side.
Other ways of calling the accounting equation are the balance sheet equation or basic accounting equation.
Why is the accounting equation important?
To understand the importance of the accounting equation, we must know that in any company, there are three fundamental elements of its economic functioning:
- Company assets
- Liabilities of the company
- Shareholders’ equity
These three elements will appear in an accounting equation. Therefore, it is a tool that reflects both the main aspects of the balance sheet (liabilities and assets) and the presence of owners’ equity.
Within these three elements, assets are the valuable resources owned by the company and related to the activity. Liabilities are usually associated with obligations. Passives and shareholder’s equity are the basis for financing the assets.
For example, it is shown as a liability if the financing is through debt. If the funding is done through equity issuance, it is shown as shareholder equity.
In short, through the accounting equation, it is assessed whether or not a business transaction that the company has carried out is reflected in the accounting books.
What are assets?
Assets are those that include liquidity but also other items that are common for companies.
For example, cash and cash equivalents, liquid assets including certificates of deposit, bonds, etc., are considered assets.
Inventories may also be considered assets. Similarly, balances receivable and invoices advanced are often considered assets.
However, traditionally, property such as buildings, machinery, etc., is considered companies’ main assets. They are considered fixed assets that are maintained over time.
What are liabilities?
Liabilities in the accounting equation will be represented by the company’s debts and the costs that must be paid to keep the company running.
Debt is understood as a liability. This liability can be either a loan or financing tool or obligations incurred for deferred invoicing. Costs include rents, salaries, dividends, taxes, etc.
The amount of shareholder equity is considered to arise from the company’s total assets minus total liabilities.
Therefore, it could be the amount of money left over when the company liquidates all assets and pays off all liabilities. If this money is distributed to the shareholders, it would be the equivalent of the equity amount.
Another important element is the so-called retained earnings. They are a part of the shareholders’ equity. This figure will be obtained by adding all profits not paid to shareholders as dividends.
How the accounting equation is calculated
Although several variations can be applied, the common formula for the accounting equation is that the result arises when the sum of liabilities plus equity equals assets.
The common steps for this type of application (in a simplified version) would be as follows:
- Calculate the total assets within the balance sheet for the period to be represented.
- Locate and sum up all liabilities. These will generally be listed separately within the balance sheets.
- Locate the shareholders’ equity and add the number to the liabilities.
After these steps, the result should reflect the relationship between assets and the sum of liabilities and shareholders’ equity.
Does the accounting equation have limitations?
Yes, it does. Theoretically, balance sheets are balanced. However, there are aspects that an accounting equation will not be able to reflect.
For example, it will not be able to tell you the real performance of companies. It is a very general number that needs to be interpreted. On the other hand, other tools are much more suitable for analyzing the day-to-day performance of a company’s internal finances.
All in all, this is an important calculation, but it needs other complementary tools for a general overview of the internal economy of companies.
When the company’s equity increases, assets will generally increase. Conversely, if investments decrease, the firm’s equity will also decrease. Adding liabilities will reduce equity while subtracting liabilities (e.g., debt repayments) will increase it.
As we can understand, these are basic concepts within accounting economics that should always be represented in any sound business economy.