What is the Balance Sheet Equation?
Balance Sheet Equation states that the sum of the owner’s capital and company’s total liabilities is equal to the company’s total assets at a particular point of time and it is fundamental of accounting which provides the basis of double-entry system of accounting.
It also known as the accounting equation is the foundation of the accounting system of double entry. The basic accounting equation shows that the sum of all the assets of the company is equal to the sum of all the liabilities of the company and its owners’ equity.
It is the most fundamental and basic part of accounting and ensures that for every debit there is an equal and opposite credit and the balance sheet remains always balanced.
The basic balance sheet equation applicable to the sole proprietor is:
Assets = Liabilities + Owners’ equity
And the balance sheet equation applicable to a corporation is:
Assets = Liabilities + Stockholders’ equity
Components of the Balance Sheet Equation
There are three components –
- Assets
- Liabilities
- Owners’ Equity/Stockholders’ Equity
#1 – Assets
Assets are the resources owned by the company having a future economic benefit. Assets can be tangible like plant & machinery, cash etc. or intangible like goodwill, patent or trademark. Assets are resources that can be converted into cash. Assets are recorded at their monetary value in the balance sheet.
#2 – Liabilities
Liabilities are the present obligations of the company which arises from some past event and for settling these obligations the resources of the company is utilized. It is the amount a company is obliged to pay to the outsiders of the company. Liabilities include accounts payable, loan taken by the company, wages and salaries payable,
#3 – Owners’ Equity/ Stockholders’ Equity
Equity shows the amount which is contributed or invested by the owner or the shareholders respectively into the business plus the income generated in the business which is not withdrawn by the owner or distributed to the shareholders. In financial terms, the income left with the company for its use is known as retained earnings and is added to the equity. When the enterprise is sole proprietorship we use the word owners’ equity as there is a single owner but when we talk about a corporation we use the word stockholders’ equity. When all the outside claims are added up to shareholders’ equity we get the amount equal to the total assets of the company.
Example#1
We can take the example of ABC Corporation which reported the following items on its balance sheet:
- Liabilities of the corporation: $150 million
- Shareholders’ equity: $100 million
- Assets of the corporation: $250 million
Now adding the liabilities and the shareholders’ equity we get $150 million + $100 million = $250 million which is equal to the assets.
Therefore, due to the dual entry system of accounting every enterprise asset matches the sum of its liabilities and equity.
Example 2
Mr. Adel has started a business of selling mobile phones. He contributed $15,000 into the business. With this, both the asset and the owners’ contribution has increased. So the balance sheet equation after this transaction was
Assets = Liabilities + Owners’ equity
$15,000 (Assets) = 0 (Liabilities) + $15,000 (Equity)
Then after the contribution, Mr. Adel purchased 20 Mobile phones at the rate of $300 per mobile phone from a wholesaler worth $6,000 on credit. Now the liabilities had increased to $6,000 and the stock which is a part of the asset had increased to $6000.
Now after this transaction the it will be
$21,000 (Assets) = $6,000 (Liabilities) + $15,000 (Equity)
After the purchase of mobile phones, Mr. Adel received an order of 5 mobile phones at a rate of $320 per phone. So the profit earned on the sale of mobile phone was ($320 – $300) * 5 = $100. Now this gain is net income and is added to the equity.
So the final values after all the above transactions came out to be:
- Assets = $21,000- $1,500 (cost of 5 mobile phones) + $1,600(cash received from sale of mobile) = $21,100
- Liabilities = $6,000
- Equity = $15,000+ $100 (profit on sale) = $15,100
Therefore, the final equation is:
$21,100(Assets) = $6,000(Liabilities) + $ 15,100 (equity)
From the above example, we can see every transaction has a dual impact. After every transaction the equation holds true.
Advantages
- It helps to determine the credit on each and every debit in the books of accounts and vice versa.
- It makes easier for the management to figure out the value of the third component of the accounting equation if the values of two other components are known.
- The accuracy in the practice of accountancy is maintained by the accountants because of the accounting equation.
- It helps the management to track errors occurred while preparing the financial statements.
Disadvantages
- The Balance sheet equation does not provide the detailed effect of the transaction. It only matches the debts with the credits but fails to specify the reasons for the same.
- It focuses only on the items of personal and real accounts not the items of nominal accounts. Nominal accounts include expenses and incomes of the business and both expenses and incomes are not balance sheet items. So they are not a part of the accounting equation directly.
- It provides a basic understanding of the dual entry system of accounting but does not state the reason behind its use in accounting.
Limitations of the Balance Sheet Equation
The balance sheet equation always balances out the balance sheet but it does not give the idea to the investor about the working of the company. For analyzing the performance investors have to interpret numbers shown and performance that whether the company has enough assets, whether liabilities are too much or too less and whether the company used proper financing option in order to attain the growth in the long term.
Important Points
- The two main components of the balance in any company which helps in knowing its financial position are assets and liabilities. The third section includes the shareholders’ equity or Owners’ equity.
- The balance sheet equation is also known as accounting equation or basic accounting equation and is the representation of how the three important components, assets, liabilities and shareholders’ equity are associated.
- The valuable resources that the company holds are its assets and the obligation which the company has to others are its liabilities. The shareholders’ equity and liabilities show that how the financing of the company’s assets are done where financing through debt is represented as liability and financing through the issue of equity shares is represented as shareholders’ equity.
- It provides the picture to the stakeholders of the company about whether the business transactions are shown accurately in the books and accounts.
Conclusion
The balance sheet equation is the foundation of the dual entry system of accounting. It shows that for every debit there is an equal and opposite credit and the sum of all the assets is always equal to the total of all its liabilities and equity.
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