The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down into assets and how they get sources (either through equity/capital or liability/debt).
Introduction to the Accounting Equation
When building up a financial statement, the most basic way to do it is by leveraging a technique called an accounting equation.
Far from being complex math, this is a very simple way to balance a financial statement, as it enables a company to build a proper accounting for its financial books by making sure that its equity is always backed by either assets or liabilities.
Accounting Equation Explained
If you look at the balance sheet, its basic premise is it uses the double-entry system.
Double-Entry System Explained
By using the accounting equation and the double-entry system, you can build the most important financial document: the balance sheet.
Balance Sheet Explained
Once you do understand the above, explained in very simple terms, you’re ready to “close the books” or to balance the accounts.
Income Statement Explained
How to Close the Accounting Books
Case study: Imagine you are starting a company that manufactures biscuits. Besides the cost of running the operations, you need the machine to produce them.
In total, for the machine you need $100,000.
The purchase is financed: 80% through equity and 20% through debt.
Even though this transaction is one step in the real world, it becomes three steps in the accounting world:
Step 1: Initially your balance sheet will show $80K under cash and equity, since remember that you will contribute 80% of $100K to buy the machine. The transaction will look like the following:
Step 2: Next, you will borrow $20K from the Bank as long-term loan, since 20% will be financed with debt. It means, you will show $100K under cash now ($80K + $20K). On the other side, you will show $80K under equity and $20K under liability. The transaction will look like the following:
Step 3: With the resources acquired you will buy the machine that will cost you $100K. The machine will show as a long-term asset on the balance sheet. This asset, financed with $20K as a long-term liability and $80K as Equity.
Video Case Study on How Balance Sheet And Income Statement Interact!
Core principles of the accounting equation and double-entry system
First, Assets always equals Liabilities + Equity.
Second, what is a one step transaction in the real world becomes a three steps transaction in the accounting world. I am sure at this point you are thinking of accounting as of “the art of making easy things hard”.
Although, I can assure you that once you internalize the two principles above you will see the light. To develop an accountant mindset you must always ask yourself “What is behind this transaction?”
Indeed, in today’s world accounting software do not allow you to understand what is going on behind the scenes. Thereby, once you keep in mind the two principles above, transactions that before you did not understand will suddenly reveal to your eyes.
At that point you will understand what I mean when I say that accounting is simple. Once you reach that enlightenment level the whole financial world will unravel to your eyes.
Suddenly, this deeper level of understanding will make you love the subject. You will no longer be like a car designer who does not know how the engine works. Therefore, each time the designer has to add a feature to the car skeleton he has to stop and wait for the engineer approval.
In conclusion, the balance sheet is divided in two main parts. The first part is the one dedicated to Assets. Within it you will find two sub-sections:
- Current Assets.
- Long-Term Assets.
On the other hand, the second part is dedicated to liabilities and equity (sources of finance). Within that you will find two sub-sections:
- Liabilities: Current and Non-Current or Long Term Liabilities.
Keep in mind the balance sheet is a picture of the business in that moment. Where, the P&L is like a collage of pictures taken in the whole year.
What Are the 3 Elements of the Accounting Equation?
The key three elements of an accounting equation are: assets, liabilities, and equity. These three elements sit on a balance sheet, where you have both short and long-term assets on one side. And on the other side, you get liabilities (short and long-term) and the shareholders’ equity. A balance sheet is a document where you must balance assets on one side with liabilities and equity on the other.
How do you calculate accounting equation?
In straightforward terms, the accounting equation states that assets always equal liability plus equity. That’s how you will build a balance sheet, a critical financial document showing a company’s current snapshot in a given period. The balance sheet and the income and cash flow statements represent the three fundamental financial statements that any company should be able to monitor to be financially viable.
Why accounting equation is important?
The accounting equation is the fundamental element that enables to build of some of the critical financial statements that help represent a company from an accounting standpoint. Indeed, from the accounting equation, you can derive the balance sheet. And from the balance sheet, you can also derive the income statement and cash flow statement.
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