What is the meaning and definition of accounting equation?

Believe me, understanding this basic formula, can do wonders in making your life simpler with finance and accounting in general.

Whether you are a CA candidate or a financial analyst?

Maybe you are a non-finance student facing this horrific concept?

It’s pure logic! Let’s get started.

Key Takeaways

1. Assets= liabilities + Equity, the golden formula is the basis for all accounting calculations i.e balance sheet equation

2. The principle works on that after each transaction both the assets and liabilites side should balance

3. For example:A company buys a car worth $10000, in this case also the assets will increase by the cost of the car($10000), the cash will reduce with the price of the car(if purchased with cash).

Table of Contents

  1. Decoding the accounting equation
  2. The logic behind the formula
  3. Components of the accounting equation
  4. Practice case
  5. Limitations of the Equation
  6. Use cases

Decoding the Accounting Equation

If we stop looking at accounting from an academic perspective but use a rather practical common sense approach. Then this equation will be child’s play to understand.

Think about this

In the ordinary sense of conversing, every transaction we do is either increasing our overall wealth or decreasing it.

So let’s take some ordinary examples that we face every day:

1: Salary – Increasing

2: Paying electricity bills- Decreasing

3: Buying a gadget ( mobile phone)- Increasing and decreasing

4: Buying a gadget on EMI- decreasing

5: Having a credit line with our grocery store- decreasing

6: Lending friends some cash- Decreasing and increasing

Very ordinary transactions aren’t they?

But what if I told you, that we could actually create a detailed financial statement on these 6 transactions?

So what’s the basic accounting equation?

In the end, all of these transactions can fit into this equation, Assets = Liabilities + Equity

So Let’s get to the logic of this in the next section!

Logic Behind the Formula?

First and foremost try answering, two simple questions with every transaction.

  • Is the transaction related to one year or multiple years?
  • Is there any cash exchange in the transaction?

The most important area of knowing what goes in the balance sheet and what goes in the income statement is the current year versus the future.

let’s decode this with the same examples.

1: Salary: You receive the salary, (after rendering your service for the month) in cash

The two keywords here are after and cash.

That means both these transactions are related to one year and really aren’t creating a need for us to remember the future commitments.

We worked for that given month and we got the salary in cash, that’s it!

Hence first of all the salary is income, so it goes to the income statement but remembers that the income statement works on

Revenue – Expenses = Profit

So in this case our revenue = salary, and at the moment we don’t have any expenses so the profit is the same as revenue.

However, what if after 10 years you want to see how you performed?

It will become very tedious to keep looking at each income statement and then add.

So what’s the solution? Simply let’s take the profit and add it to retained earnings.

Of course, this means that the salary you got was not spent but retained as savings.

Testing this Logic Part 1

At this moment, let’s explore this transaction completely!

The flow is revenue than profit, leading to retained earnings.

Of course, you have cash, right? To increase cash, which is an asset by the same amount making both the side balance.

So the key takeaways to remember here are:

  • The Equity side of the equation is linked to profits.
  • The asset side is linked to cash transactions and total credits in terms of income.

Testing this Logic Part 2

Paying electricity bills and buying the mobile phone with cash or a loan, how’s that going to work?

Well! Again let’s get to the basics first,

  • Is the electricity bill paid for using the electricity this year and is it paid in cash?

The answer could be, Yes!

In fact, it is paid after using the electricity, at least that’s how it works in India.

Now your next question could be, what if it was paid in advance?

Well, I will get there, just hang on!

So the expense qualifies for the equation, Revenue – Expenses.

Second it then it reduces our profit and finally reduces our retained earnings

But what about the assets side?

The same flow debits cash on the asset side.

Testing the logic Part 3

Well now let’s test the buying of gadgets first with second cash and later see how it works with the loan.

The first question: Is it bought to be used only for one year?

Of course not! This asset or mobile phone can be used for multiple years right?

Then the problem is, how can we put the entire mobile phone expense in the income statement?

Remember? The income statement is just for one year. Now before you run for cover and apply complicated terms.

How about we simply divide the mobile phone cost across multiple years?

Yes! Simply evenly distribute the expense across years, makes sense?

So now how would that work out in the equation?

First and foremost let’s deal with this in two parts: Buying first and expensing second.

When we bought the mobile phone, it created an asset. So asset increased? But how does the equation balance?

It balances with cash reduction since we are buying it with cash.

Secondly, how does the expense get recorded?

The distributed expense reduces the income in the form of depreciation, which reduces retained earnings.

Similar to the asset side, it reduces with the depreciation.

Increase expense with the distributed mobile phone cost, and reduce retained earnings.

What would have happened if we had bought the same with a loan?

Simple! The cash wouldn’t be affected but Liabilities would increase with the loan amount.

Summarising the logic

If you got the logic then we are in a position to summarise this logic in terms of an equation:

Assets = Liabilities + Share Capital + Retained earnings,

Further, you could decompose the basic accounting equation, further as:

Assets = Liabilities + Contributed capital + Begining Retained Earnings + Revenue- Expense- Dividends

Where:

  • CC = Contributed Capital (comes from capital provided by shareholders)
  • BRE = Beginning Retained Earnings (carryover retained earnings that were not given to stockholders)
  • R = Revenue (comes from sales and operation)
  • E = (-) Expenses (costs associated with running the operation)
  • D = (-) Dividends (earnings distributed by the company to its shareholders)

Hopefully, you have understood this and I would recommend you test your understanding with various examples.

Test your Understanding

Let’s say you start a company with $100,000, and you buy machinery worth $15000 and at the moment you have not started your business.

Then what would be the two entries in the accounting, equation?

Answer:

Assets =$15000

Cash= $100,000-$15000= $85000

Total assets = $100000

Equity Capital= $100,000

Total Capital + Liability = $100,000

Hence the two sides match.

Components of the Equation

Let me give you a brief break-up of what all are included in these main headings, of the accounting equation formula.

Capital

Although I am oversimplifying for now capital in accounting includes total stockholders equity.

  • Common share capital: In a business context, this is the initial money added to start the business
  • Preference share capital: Still the capital but with rights on fixed dividends
  • Preference convertible capital- Capital with fixed dividends and converting to common equity option.

Liabilities

Similarly, let me show your what Liabilities can include both short-term or long-term?

  • Accounts Payable: Things taken on credit from suppliers
  • Short-term loan: Loan taken for short-term purposes like working capital
  • Long-term loan: Debt taken for expansion
  • Salary Payable: Salaries were not paid in cash but were supposed to be paid
  • Unearned revenue: Advance cash received from customers but services not rendered

Assets

What about Assets? Assets are simple to understand.

  • Cash in bank: Simply the cash accumulated over years of operations
  • Accounts receivable: Product or service rendered but cash not received.
  • Fixed assets: Assets to be used for the long term in the business. May include machinery, equipment etc

Some Random Transactions

The double entry system is magical and revealing, as ultimately works on debit and credit

Simply put the system says that after every transaction, no matter how small or big it is the accounting equation will balance.

let’s try with some simple examples of transactions

  1. Buy Raw materials with Cash: Effect- Asset increases and Asset ( Cash decreases) with an equal amount. Leading to its balance again
  2. Buy Raw material on credit: Effect- asset increases( raw materials) and Payables increases (liabilities) with the same amount
  3. Sell products on cash: Effect -revenue increases (leading to an increase in retained earnings leading again to an increase in equity).
  4. On the other side of the equation, the cash increases with the same amount
  5. Sell products on credit, Effect- revenue increases (leading to an increase in retained earnings leading again to an increase in equity).
  6. On the other side of the equation the accounts receivable increase with the same amount

That’s the beauty of the double entry system, it always balances.

Limitations

I won’t really call this limitation but what the accounting can’t really capture are:

  • Quality
  • Human resource

Although I could argue that both get captured in the performance of the company itself. However, I would like to comment that, the accounting equation’s biggest necessary evil is accrual.

The accrual system is both a necessity, as well as an evil which can be used to show a very rosy picture.

Accrual means, the non-necessity of exchange of cash for it to be recorded as revenue.

Think about a real estate company, as per the accrual rules the company doesn’t even have to sell it to record revenue.

It can use the percentage completion method of the project and record the revenue.

The Importance of the Accounting Equation is that.

Without them, it would be impossible to understand how a business performs or even keep tabs on the various transactions of the company.

The company’s liabilities include shorter-term liabilities and long terms. Short-term liabilities include business related like accounts payable, short-term working capital debt and long-term include long-term debt.

Use Cases

The real-world application of the equation is immense in finance, and as I said in the beginning if you get this logic your life will be easier with advanced concepts.

You may try to use the below video, to see how this gets used in financial modeling

Summary
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ALLEN ARAVINDAN,CFA

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