What is Accounting Equation Formula?
The term “accounting equation” refers to one of the basic principles of accounting that forms a fundamental element of the balance sheet. It is the base of double-entry accounting technique and it underlines the structure of the balance sheet. The balance sheet can be categorized into three major parts: Total Assets, Total Liabilities, and Shareholder’s / Owner’s Equity. The formula for the accounting equation is built on the basis of these three major parts.
The accounting equation formula can also be rearranged and represented in the following form,
Calculation of Accounting Equation (Step by Step)
The accounting equation can be calculated by using the following steps:
- Step 1: First of all, gather the value of all the items that the company owns. These items are known as assets and they may be tangible or intangible in nature but should belong to the company. Examples of assets are cash, equipment, accounts receivable, inventory etc.
- Step 2: Next, gather the value of all the items that the company is obligated to pay in the short term or the long term. These items are known as liabilities. Examples of liabilities are long term debt, short term borrowings accounts payable etc.
- Step 3: Next, determine the total equity which is the sum of the amount of money that the company has raised through the process of shares issuance and the amount of retained earnings of the company. Mathematically, i.e Total equity = Share capital + Retained earnings
- Step 4: Finally, the formula is derived which is represented by total assets that are equal to the sum of total equity and total liabilities as shown below.
Total Assets = Total Liabilities + Total Equity
Let us take the example of a case where a machine has been purchased with cash. A company named ABC Ltd plans to buy a machine worth $8,000 using only cash. Show the accounting impact of the transaction on the balance sheet of ABC Ltd.
The below transaction will result in a debit entry recorded in the equipment account (+$8,000) and a credit entry is recorded in the cash account (-$8,000). The overall effect of the transaction on the accounting equation will be as follows:
The above transaction impacts only the total asset in the left side of the equation and as such, there isn’t any corresponding impact in the liabilities or total equity in the right side of the equation.
Let us take another example of a case where equipment has been bought with a mix of both cash and credit. A company named PQR Ltd plans to buy equipment worth $7,000. But the company has only $3,500 of cash in its bank deposits. However, the seller is an old acquaintance of the business owner of the company and as such the company is allowed to buy the equipment with an initial payment of $3,500, while the remaining amount will be owed by the company. Show the accounting impact of the transaction on the balance sheet of PQR Ltd.
The below transaction will result in a debit entry to the equipment account (+$6,000) and a credit entry to both cash account (-$3,500) and accounts payable account (+$3,500). The overall impact of the transaction on the accounting equation will be as follows:
The above transaction impacts both sides of the accounting equation equally. In this case, both the left side and the right side of the accounting equation will increase by +$3,500.
Let us take another example of company ABZ Ltd. On January 1, 2018, the company started its business of soft drinks manufacturing. On February 1, 2018, the company recorded a transaction wherein they have liquidated a short term investment of $50,000 in exchange for 10,000 shares of its own common stock. It is to be noted that there was no revenue booked because no delivery happened on that day. Show the accounting impact of the transaction on the balance sheet of ABZ Ltd.
The below transaction will result in a debit entry to the share capital account (+$50,000) and a credit entry to a short term investment account (-$50,000). The overall impact of the transaction on the accounting equation will be as follows:-
The above transaction in this case also impacts both sides of the accounting equation. Here, both the left side and the right side of the accounting equation will increase by +$50,000.
Relevance and Use
It is very important to understand the concept of accounting equation because it is considered to be the foundation on which the double-entry accounting system is built. It is the representation of a company’s balance sheet wherein the total assets equal the summation of its total liabilities and total equity.
Note that the total assets capture all the valuable resources that are owned by the company, the total liabilities captures its obligations. Anyways, both total liabilities and total equity of a company show how its assets are financed. If the financing has happened through debt, then it will show as a liability, and if the financing has happened through issuing equity shares to investors, then it will show in total equity.
This has been a guide to what is Accounting Equation Formula. Here we discuss how to calculate the accounting equation using practical examples and downloadable excel template. You can learn more about Accounting from the following articles –