What is the Accounting Equation?

Overview

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.

Definition

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.

Formula

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.

Explanation

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.

Examples

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.

Conclusion

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.

Is cash debit or credit?

Explanation:

Cash is the company’s current assets holding for small expenses in the office or for a certain large amount of cash transactions. For example, the company holds petty cash for making payments on small office expenses.

Sometimes, the company might keep a large amount of cash for making payments to certain suppliers that accept only cash rather than bank transactions like bank transfers or check.

The company might also holding the cash that its collect from customers but these kind of cash will be deposit into the company’s bank account in the following day.

It does not matter whether the cash is used for small or large payment and it does matter if the cash is collected from customers or from whatever sources, from an accounting perspective, cash is considered as assets and it is classified as current assets which are reported in the balance sheet.

Is cash debit or credit?

Before dive into the debit or credit, we need to assess what kind of financial statements element that cash belongs to. Once we know the exact element, then we can clearly know whether cash is debit or credit.

As we mentioned above, cash is the assets and clearly it is belonging to the assets element of the financial statements.

As long as it is belong to assets element, the rule of debit or credit is apply the same.

Assets reporting in the balance sheet or statement of financial position. Decreasing asset result in credit records and increasing assets result in debiting to assets.

For example, if the company purchase new computer, then asset is increasing. We need to debit assets.

The same as asset,

In financial statements, cash is debit when there is increasing in it. For example, the company receives the payment from the customers in cash. In this case, cash is increased and we need to debit it. If the cash is decreasing, then we need to record it on the credit side of the cash account.

For example, the company makes the payment to its supplier in cash. The cash is decreasing since the company making payments to its supplier through cash.

Cash journal entries:

The journal entries of cash transactions are similar to the journal entries of others assets account.

Here is how we record cash when it is increasing due to correct from customers,

AccountDrCr
CashXXXX 
Account recievable/sales XXXX

For example, the company receives the cash payment from its credit customer amounting to $1,000. Then, the entries are as below:

AccountDrCr
CashUSD1,000 
Account recievable/sales USD1,000

Here is how we record cash when it is decreasing due to payment to suppliers,

Example, the company purchase office supplies amouting to USD500 and it pays its supplies throught petty cash, then the entries are as blow:

AccountDrCr
Office suppliesUSD5000 
Petty cash USD5000

Cash as an asset:

An asset is defined as the resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Another criterion is:

  • The inflow of economic benefits to the entity is probable
  • The cost/value can be measured reliably.

Similarly, the value of cash can be measured reliably since it can be easily counted. Cash is always in the control of the company either with itself or its custodian as a bank. Cash is classified as a current asset. Current assets are assets that can be easily converted to cash and cash equivalents within a year or working capital cycle.

Cash can be also classified into tangible assets since it has a physical presence and can be touched. Cash can be defined as an operating asset since it is required in the daily operation of the business. In another sense, they are used to generate revenue from the company’s core operations.

Features of cash:

  • Durability: Cash is highly durable and lasts long unless torn. It can be exchanged from banks if torn.
  • Portability: It can be taken from one place to another easily. It is light weighted.
  • Divisibility: Cash can be easily divided into smaller values. For example, a thousand-rupee note can be easily divided into 10 hundred-rupee notes.
  • Limited supply: Cash is printed by central banks as per requirement and is in limited supply in the markets.
  • Uniformity: Cash of different values comes in the same shape, size, and value.
  • Acceptability: Since currency notes are printed and allowed for use by central banks, they are accepted everywhere.

Uses of cash:

Cash can be used for various purposes. Such uses can be categorized into three main uses viz.

  1. Operating use:

Cash is used for payment of operating expenses. The different expenses    used for cash payments are:

  • Payment to account payables and creditors
  • Payment of business expenses
  • Payment of interest to lenders
  • Payments for purchase of raw materials
  • Payment for income taxes
  • Cash paid to vendors and suppliers
  • Receipt from sales and debtors
  1. Investment use:

Cash is used for investment purpose. The different investment activities are:

  • Purchase of fixed assets
  • Investment in securities
  • Selling or leasing of fixed assets
  • Selling off securities
  1. Financing use:

Cash is used for the payment of loans, dividends. It is used for transactions involving debt, equity, dividends. It is used to manage the capital structure of the company. Cash moves here between a firm and its owners, investors, and creditors. The financing use of cash involves:

  • Issue of stock equity, debt
  • Payment of loan, dividend
  • Raising loans and debentures
  • Redemption of debt
  • Stock repurchases

Conclusion: The item ‘cash’ is therefore DEBIT. It is shown as an asset owing to the advantage it brings to the business. It is therefore shown under the Current Assets of the Asset side of the Balance sheet.

How to Safeguard Company Assets?

Your success in business does not just depend only on your ability to make sales profits. You have to also learn how to properly manage and safeguard your company assets; they are what makes the profits for you.

Company assets are the valuable properties that your company owns. They include tangible physical business properties like lands and buildings, vehicles, office equipment, inventory, etc.

Also, intangible valuables such as brand, trademarks, patents, and intellectual properties all count as intangible business assets.

Your assets determine your business value. So, it is only wise that you learn how to maintain these assets for maximum business output.

Why Do You Need to Safeguard Your Assets

Your business assets help your company to generate revenue and add to your business value. You also need them for the efficient running of your day-to-day activities.

Damages to or loss of these business assets can affect the general health of your business. Resources spent on replacements and repairs increase business expenses and reduces net profit.

So, if you don’t take proper care of your business assets, you are risking huge business losses.

How to Safeguard Your Assets

Different assets have different kinds of risks associated with them. Since the goal is to prevent or at least minimize those risks, different measures can help safeguard your assets.

Proper Documentation and Monitoring

You must keep records of all your assets and track the activities associated with them.

For example, maintaining accurate inventory records can help you trace any missing or stolen goods. Regular machinery checks can also help you notice faults or potential damage risks more easily and fix them before they result in any serious harm.

Insurance

Physical assets are susceptible to dangers such as robbery, fire outbreaks, and other environmental hazards.

So you might need to get good insurance coverage for your vehicles, buildings, and other tangible assets. That way, you don’t have to worry much about repairing or replacing them.

Regular Maintenance

Machinery can wear and tear with time and consistent usage. You need to have a regular maintenance schedule to keep them in steady proper working conditions.

Even your employees might need vacations, annual assessments, and other routines to maintain high productivity and efficiency.

Intellectual Property Protection

Brand recognition and reputation, for instance, go a long way in determining your competitive edge and even volume of sales.

You can employ professional legal services to help guard against intellectual thefts or copyright infringements.

Physical, Digital, and Data Security

You can employ a viable security team or contract a security company to help protect your physical properties.

The use of security cameras can also help you monitor activities around your company environment right from the comfort of your office. You can also use vehicle tracking systems to monitor your company vehicles or even recover stolen machinery.

Cyber Security should also be given maximum attention. Ensure that sensitive information such as customer passwords, account statements, etc are fully guarded against unauthorized access. You can hire a cybersecurity expert for professional security services.

Bottom Line

If you keep incurring unnecessary expenses due to poor assets management, it will eventually tell on your business’ general performance.

So you need to do everything possible to take care of your assets and safeguard them against possible risks.

How to Safeguard A Company’s Cash?

There are a lot of risks associated with running a business and managing its assets. Learning how to safeguard your company’s cash is one of the viable ways to minimize those risks.

Cash is a very important asset for every business. It provides a quick and reliable means of making and receiving payments without much hurdles. Cash transactions are also less complicated to evaluate and document.

Whether it is cash-in-hand or cash equivalents, it is important you implement useful strategies in guarding against possible cash risks affecting your business.

1) Get a Company Account

As a business owner, it is sometimes hard to separate your business money from your personal finances. This is particularly difficult if your personal money is your major source of business capital.

If you’re running a sole proprietorship where you are in charge of everything, there is a higher tendency for inadequate business records. Maybe because there’s no one else to possibly check and balance your financial activities.

This is where a company account comes in very handy. With that, it is easier for you to accurately monitor your transactions through your company account’s financial statement.

For larger companies, a corporate account offers better restrictions to cash flow and improves account transparency.

2) Reduce Cash Redundancy

Having too much extra cash around your offices can be very tempting. You can be lured into unnecessary spending and can easily misplace money. Your employees can easily be tempted to “borrow”from company cash (and sometimes never return) or even steal them.

To avoid this, always deposit surplus cash into the bank on a regular basis, probably daily or at least once a week.

3) Restrict Access to Cash

The lesser the number of people with access to company cash, the easier it becomes to collate accurate accounts. If anything goes wrong, you would know who exactly should be held accountable.

Also, you can ensure that there are more than one signatory to your corporate account. That way, one person cannot just make transactions anyhow s/he wants. It improves the integrity of the transactions on the account.

4) Establish a Transaction Approval System

Transactions on the company account, especially withdrawals, should always be endorsed by appropriate authorities.

You can set up a system that verifies every transaction for approval before effecting them. The reasons for payments must be authentic and reasonable too.

5) Use Other Means of Payment

One downside of using liquid physical cash is that it is not recorded real-time into the bank statement. This can cause issues in a case where a transaction is recorded but the money was not eventually sent into the account.

You can use other payment methods that can reflect directly on the bank statement, such as bank transfers, cheques etc.

6) Issue / Collect Receipts

A transaction without proof can easily be denied or altered. Whether you’re receiving or giving out cash, always document the receipts.

Bottom Line

Proper management and security of cash assets is very instrumental to the general safety of your business.

Loss or misplacement of cash can reduce both your business value and your purchasing power. So it is only wise that you safeguard your company cash as much as you can.

Accounting for equity reserve

Meaning of Equity Reserves

Reserves refer to a component of shareholders’ equity, the amount kept apart for estimated claims or creation of contra asset accounts for bad debts. Reserves always have a credit balance. The reserve which belongs to equity shareholders or where it is marked for any purpose is equity reserves.

The reserves appear in shareholders’ equity except in the computation of contributed share capital. Inequity section of the balance sheet, stocks are issued at a discount, par, or premium. The latter options are widely used.

When shares are issued at premium, the par value goes towards the basic share capital. Any amount above par will be considered as share premium and will be added to Paid up capital-share premium account. This is just one such example of equity reserves to give nuance of the concept.

The company operates in a business environment and strives to obtain higher and higher profits each year. The net profit is obtained by deducting the expenses from the revenues. The net profits are appropriated to reserves and surplus.

The profits are transferred to reserves and surplus after paying off the dividend to equity and preference shareholders which forms part of equity reserves. Many more such equity reserves form the balance sheet.

Types of equity reserves and their accounting treatment

Equity reserves form part of the Equity Section of the Balance sheet. It is a part of stockholders’ equity which is unmarked for any purpose and is residual in nature. The general presentation of equity reserves in the balance sheet is given below:

Liabilities and Capital SectionAmount ($)
Share Capital 
        Equity share capital, at parX
        Preference Share capital, at parX
Reserves and surplus 
        Securities Premium – EquityX
        Securities Premium – PreferenceX
        General reservesX
        Retained EarningsX
Total Liabilities and CapitalXX

The Bolded portion is all part of Equity reserves. By equity, we mean the common shareholders. The equity reserves are distributable to equity shareholders.

Now, we move ahead to discuss varieties of equity reserves and their accounting treatment:

a. Foreign Currency Translation Reserve

We are almost living in a borderless society in terms of business transactions being done. Hence, the company is likely to get exposure to foreign currency as a result of business transactions or as a result of a corporation set up with associates or subsidiary. These transactions have to be converted into home currency in order to prepare financial statements.

Any losses or gains would depend on the exchange rates and would directly come out of equity pocket and benefits to be only given to them. Various methods of translation such as the current rate method, temporal rate method, and monetary-nonmonetary translation method shall be used.

Accounting treatment

The GAAP provisions state that items in the balance sheet should be converted in accordance with the rate of exchange on the date of the balance sheet while the income statement items shall be converted according to the weighted average rate of exchange. Any gains or losses arising from foreign currency transactions are recorded in the equity section of the balance sheet.

b. Revaluation Reserve

When the fixed assets are purchased, they are recorded using cost method or revaluation model. In case of revaluation model, all fixed assets would be revaluated on reporting date.

There would be a difference in the balances of these fixed assets on each such date. These revaluations would be recorded as revaluation reserves, part of equity reserves.

Accounting treatment

The changes due to revaluation would not be reflected in income statement until the fixed assets are disposed of. These will only be shown in the equity section of the balance sheet.

c. General reserved/ Retained Earnings

The businesses earn revenues throughout the year. With successful planning, they are able to churn out the net profit for the company.

Accounting treatment

After payment of dividends, the net profit is transferred to general reserves or retained earnings which is shown in the reserves and surplus side of the balance sheet.

d. fair value through other comprehensive income.

The fair value approach lays down various criteria. The financial assets and liabilities which meet such criteria impact the equity reserve. The value of financial instruments’ value is dynamic in nature. Before the disposal of such financial instruments, they should be reported in the balance sheet.

Accounting treatment

Any gain or loss realized from the sale will be recognized only after they are settled. Such gain would impact the Other comprehensive income i.e. through FV-OCI as per GAAP provisions.

How are unearned revenues present in the balance sheet?

What is Unearned Revenue?

Unearned revenue is amount of money that is received by the business for goods and services that is yet to be delivered or rendered. Unearned revenue can also be interpreted as revenue received in advance from customers but the performance of service or delivery of goods would be done later on.

Hence, the business creates the liability in its balance sheet till goods or services are delivered or performed. Popularly, unearned revenues are also known as deferred revenue or advance payments.

Some business models regularly thrive on the basis of unearned revenue. These are businesses selling subscription-based products and which would require advance payments. Popular examples include, rent payments are made in advance, prepaid insurance, airline tickets payments, newspaper subscriptions and payments for the use of software.

Receiving money in advance is very beneficial for the business to thrive. The revenue received early can be used in various ways like prepayment of debt or making requisitions of more inventory.

Recognition of unearned revenue

Unearned revenues provide various clues into how the company would be able to generate revenue in the coming quarters of reporting. The figure of unearned revenue becomes great importance to investors. Netflix is based on subscription model. The coronavirus although resulted in spurge of demand for Netflix.

Not every business has been spared. Take for example football sports club. They usually allow for annual subscription to fans to watch all the games. Manchester United for example would have to refund all the yearly fees it received from football fans for annual ticket membership fees.

This is meant to say things can go both ways in case of unearned revenue. The business may have to refund the unearned revenue in case of adverse circumstances.

There are three ways to record revenue. In case of accrual revenue, revenues are recognized at the time of performance of work. This is the general approach to record revenue and is in line with accounting principles. In case of deferred revenue, which equates to unearned revenue, the cash is received before the revenue has to be recognized as per accrual system of book keeping. T

his approach considers unearned revenue as a liability until the goods or services are delivered or rendered as the case may and then the revenue shall be identified. Another common transaction is when the business receives cash at the same time the goods or services are provided. In that case, revenue will be recorded impromptu.

How Unearned Revenue is Reported?

Unearned revenue is promised service that has not been performed. Hence, such revenue which is technically not a revenue has to be reported. There are two methods to report unearned revenue. These are liability method and income method.

Liability Method

In case of liability method, the unearned revenue is considered as liability. The appropriate reason for this would be that company has not performed the service and hence, the work seems to be pending even though the cash seems to have been received.

Hence, the unearned revenue has to be reported as a liability. At the end of March, the company will make adjusting entry which looks as

Unearned Revenue and How It Is Accounted for in Business

The journal entries would look as :

DateParticularsDebit ($)Credit ($)
 CashXX 
         Unearned Revenue XX
 (To record cash received in advance from customer)  
    
 Unearned revenueXX 
        Revenue  
 (To record revenue for the services performed)  

Income method

The same payment of unearned revenue would be treated differently if the company uses income method. The income method approaches towards the unearned revenue as advanced payment as income. The general trade practice is however liability method.

Unearned Revenue in Balance Sheet

The customers do advance payments for the services they expect to be performed within a few months or a year at stretch. Hence, unearned revenue would be recorded under short term liabilities alongside trade payables. This would be reported under the Liabilities side of Balance sheet. Let’s take a short example.

Sinra Inc has received internet subscription for 3-month package from 200 customers at $ 30 dollar per customer per month in the first week of April for April to June package.

Now, in the first week, Sinra Inc has to recognize all of 200 customers as unearned revenue. This would be 200*30*3 = $ 18000

If the balance sheet is made at the end of April month i.e. at April 30, it would look as the following :

Assets$Liabilities and stockholders’ equity$
Current Assets Current Liabilities 
CashXXXNotes payableXXX
XXXXXXXX
XXXXXXXX
  Unearned Revenue                      X Less: recognized as revenue       (X)XXX
Non-Current Assets Non-current LiabilitiesXXX
XXXX  
XXXXStockholders’ equityXX
XXXX  
    
Total AssetsXXXTotal Liabilities and Stockholders’ equity