The main financial goal of a business is to maximize profits. The financial position of a business depends on the availability and structure of economic resources, which are called its assets and capital. The relationship between these two is reflected in the accounting equation. So, what is the accounting equation?
Understanding the Accounting Equation
The financial condition of any organization can be represented in the form of an accounting equation. What is the accounting equation formula? Also known as the balance sheet equation, the most basic version of it can be reflected as follows:
Assets are everything that the company owns: cash and other resources, investments, fixed assets, debts of other companies to the company. The acquisition of assets is carried out at the expense of equity and borrowed capital.
Liabilities represent a borrowed capital. These are obligations (debts) of the enterprise for the material resources and services received (purchased on credit), borrowed money, wages payable to workers and employees, and so on.
Equity represents the balance remaining after settlement of obligations. It is the owner’s share of the assets of the enterprise.
Expanded Form of the Accounting Equation
In the course of its activities, the business receives income and incurs expenses. Then, the accounting equation can be represented in the following form:
Assets = Liabilities + Contributed Capital + Income – Expenses
Income is the gross inflow of economic benefits during the reporting period arising from the ordinary course of business activities and resulting in an increase in equity. Income includes revenue from operating activities and other income such as proceeds from the sale of the property, plant, and equipment, lease payments, etc.
Expenses are a decrease in economic benefits in the reporting period in the form of an outflow or use of assets that lead to a decrease in equity. Expenses include costs and losses arising in the course of the main activities of the business. Such costs include the cost of production, sales, administrative expenses, and others.
Investments and owner withdrawals also affect the equity capital. They can also be entered into the main accounting equation. What is the accounting equation formula now?
Assets = Liabilities + Contributed Capital + Income – Expenses + Investments – Withdrawals
Accounting Equation in Double-Entry Bookkeeping
Double entry in accounting is one of the main elements in the formation of reliable information about business operations. The accounting equation forms the foundation of this accounting method. When recording each transaction, the bookkeepers must keep the equation in balance. If there is no balance, then a mistake has been made. Additionally, the double-entry system allows one to track changes both in the assets of the company and their sources (liabilities).