accounting-equation

Accounting Equation And Why It Matters In Business

Business / By / October 23, 2023

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).

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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.

Key takeaway

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.
  • Equity.

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. 

Key Highlights:

  • Introduction to the Accounting Equation: The accounting equation is a fundamental concept in financial accounting that helps in building a proper accounting structure for a company’s financial statements. It ensures that equity is backed by either assets or liabilities.
    • Assets = Liabilities + Equity
  • Accounting Equation Explained: The accounting equation serves as the foundation for the balance sheet, a crucial financial document. It ensures that the company’s financial position is accurately represented.
  • Double-Entry System: The balance sheet uses the double-entry system, a method in which every financial transaction affects at least two accounts, maintaining the balance between debits and credits.
  • Balance Sheet Explained: The balance sheet is created using the accounting equation and the double-entry system. It’s a snapshot of a company’s financial position at a specific point in time, showcasing assets, liabilities, and equity.
  • Income Statement Explained: The income statement is another vital financial statement that provides an overview of a company’s revenues, expenses, and net income over a specific period.
  • Closing the Accounting Books: “Closing the books” refers to the process of finalizing financial accounts for a given period. It involves transferring balances to appropriate accounts, preparing financial statements, and ensuring accuracy.
  • Case Study: Manufacturing Biscuits Company:
    • Machine Cost: $100,000
    • Financing: 80% equity and 20% debt
    • Accounting Steps: The transaction involves three steps in accounting:
      • Step 1: Initial balance sheet shows $80K cash and equity.
      • Step 2: Borrow $20K from the Bank, now $100K cash, $80K equity, $20K liability.
      • Step 3: Buy the machine, it becomes a long-term asset financed by $20K liability and $80K equity.
  • Core Principles:
    • Assets always equal Liabilities + Equity.
    • Transactions in the accounting world are more complex than real-world transactions.
    • Developing an accountant mindset involves understanding the underlying principles behind transactions.
  • Key Takeaway:
    • The balance sheet comprises two main parts: assets and liabilities/equity.
    • Assets are divided into current and long-term assets.
    • Liabilities and equity are further categorized into current and non-current liabilities, and equity.

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.

Connected Financial Concepts

Circle of Competence

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The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

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The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

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Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

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Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

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Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

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Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

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Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

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Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

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Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

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Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

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The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

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Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

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Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

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Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

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WACC

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The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

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A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

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Read next:

How To Read A Balance Sheet Like An Expert

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About The Author

Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
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