Accounting can be considered as one of the most important ancillary functions within the company. This is primarily because of the reason that it gives a direct insight into the performance of the company, which can eventually be used as a very important tool for decision making.
Therefore, companies put a lot of emphasis on ensuring that the accounting department and function within the company is properly managed, which requires them to have qualified accountants onboard that are well-versed with basic accounting concepts.
The accounting equation tends to be the first and the foremost element of accounting, and based on this equation, the concepts are subsequently formed. Therefore, it is absolutely necessary to have a proper understanding of the accounting equation, the components, as well as the formula in order to understand how basic accounting works.
The accounting equation can be best described as the primitive foundation of the double-entry system of accounting. It is the representation of the company’s assets, liabilities and equity that is presented in a logical format in the balance sheet of the company. The main premise of the balance sheet in this regard is to show the assets held by the company are equal to the sum of liabilities and equity held by the company at a particular date.
Therefore, the accounting equation can be explained as the basic accounting formula, or the premise by which the business functions or operates. The accounting equation helps accountants to subsequently subcategorize the respective transactions into the double entry system of accounting, so that record keeping and book keeping is done in a proper manner. It can be regarded as the very basis of maintaining accounts for any particular organization.
The formula for Accounting Equation comprises of three main components, which include assets, liabilities and equity. These components can be regarded as the main areas which define the operations and overall functions within the company. The accounting equation can be defined as the following:
Assets = Liabilities + Equity
With this equation in place, it can be seen that it can be rearranged too. This equation justifies the financial position of the company, in the sense that the real worth of the company (Total Assets), has been financed using Liabilities (Leveraging) as well as Shareholder’s Equity.
As mentioned earlier, the accounting equation broadly entails three components. These components are explained below.
Assets: Assets are the resources that are held by the company in order to function and operate in the relevant industry. In this regard, it is also important to point out that assets can be termed as intermediaries that help companies generate considerable money. Assets can either be Fixed Assets or Current Assets. Fixed Assets (also referred to as Non-Current Assets) are assets that are held in possession by the company for a period of more than 12 months, and are expected to generate returns for the company for a relatively longer time period.
Liabilities: Liabilities can be regarded as obligations that need to be honored by the company in order to settle the respective accounts. Liabilities can simply be defined as the amount that the company owes to their suppliers, in exchange of goods (or services) that have already been provided for, but not yet paid for. This also includes debt that might have been taken by the company in order to arrange for finances.
Equity: Equity, or shareholder’s equity is simply the amount that would be paid to the shareholders in the case where all the assets were liquidated, and the liabilities of the company were subsequently paid off. It includes the amount that is owed by the shareholders, as a return on their investment in the company. Shareholder’s equity includes the amount that is invested by the shareholders in the form of shares, in addition to the retained earnings that have been accumulated by the company over the course of time.
These 3 components have further subcategories that include several different transactions and account types. They are amalgamated and subsequently presented in form of a Balance Sheet that is simply a representation of the accounting equation in itself. It justifies the financial position of the company in the sense that it represents how the real net valuation of the company is derived, using the amount of assets they have in hand, minus the obligations they need to honor in order to accurately estimate the value that can be attributed to the shareholders.
Balance Sheet shows the position of the assets, liabilities, and equity of the organization on a particular date. The balance sheet basically holds the premise of the accounting equation in the following ways:
- Locating the company’s total assets on the Balance Sheet for the respective period
- Representing a summation of total liabilities that are held by the company at a particular date.
- Representing the equity that is owned by the shareholders
- Representing how the total assets owned by the company equals the sum of total liabilities and shareholders’ equity at a particular date.
For example, ABC Corporation has the following totals at the end of the respective year:
Total Assets = $200 billion
Total Liabilities = $150 billion
Total Equity = $50 billion
In order for the accounting equation to hold, Total Assets should ideally be equal to the sum of Total Liabilities and Total Equity.
Therefore, the accounting equation is basically presented in the Balance Sheet such that the total holds. If hypothetically, the total does not hold, this means that some of the transactions (or class of accounts) has been categorized improperly.
The accounting equation is considered as fundamental basis on which all accounting systems function. Rightfully so, it is considered as the main underlying framework that helps companies to organize their systems, so that they can successfully be able to extrapolate the advantages and utility derived by effective accounting systems. Without the accounting equation in proper practice, it would be extremely difficult to logically maintain financial records for the company.
The accounting equation, therefore, represents a holistic categorical classification of the types and classes of accounts maintained within the company. This classification proves to be pivotal on grounds of ensuring that the double-entry system is properly implemented, and can be presented in a logical manner to the end-user.