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The accounting equation is a formula that is foundational to accounting principles. Many think of traditional algebra when they hear the word equation. The accounting equation is more than two sides saying the same thing.  Accounting has been around for centuries, and like many ancient ideas, these concepts have changed over time.

The accounting equation is foundational; businesses record transactions in their books.  It has not been long since accounting has morphed into a systemic process executed mainly by software and automation tools. Businesses didn’t begin using computers until the mid to late 20th century. Managing accounting was a balancing act before technology came and made it efficient.

 

What Is the Accounting Equation?

The accounting equation is fundamental to accounting principles and is the first concept taught in an entry-level accounting class. Every accounting principle builds on the accounting equation formula.

 

Quick and Easy Definition

The accounting equation is the fundamental equation of accounting that states that assets equal liabilities plus equity: assets = liabilities + shareholder’s equity. It is the foundation of a company’s balance sheet, one of the critical financial statements a business generates.

The accounting equation highlights a company’s profitability. In short, investors can determine how well or poorly a business performs by glancing at its balance sheet.

 

Alternative Names + Arrangements

Other names refer to this equation. The accounting equation is also called the accounting formula, balance sheet, fundamental accounting equation, or basic accounting equation.

The accounting equation is expressed as assets = liabilities + shareholder’s equity.

Still, it can also be written out as:

• Assets = Liabilities + Owner’s Capital – Owner’s Drawings + Revenues – Expenses,
• Owner’s equity = Assets – Liabilities, or
• Net Worth = Assets – Liabilities

All four of these versions reveal the same information.

 

An In-Depth Look into the Accounting Equation:

The accounting equation is the introduction to the double-entry bookkeeping system. The double-entry accounting system began in the late 15th century. It is a method for recording business transactions that reveal how they affect the business’s bottom line.

The double-entry bookkeeping system records transactions twice. While it sounds like this recording leads to overstating records, it balances the business. It also shows how all components of the equation are relational. Not all companies use the double-entry accounting equation.

Some used single-entry accounting, where transactions are recorded once on the business bookkeeping system. This is an ideal setup for a business with few transactions. 

Double Entry vs. Single Entry

Single-entry accounting is a great way to start bookkeeping, especially for a business with limited transactions. It doesn’t need much reporting beyond a standard profit and loss statement. This is the benefit of single-entry accounting.

However, most businesses need more accounting than single-entry can provide. Double-entry accounting records transactions in a way that also demonstrates how profitable a company is becoming. Investors are interested in a business’s cash flow compared to its liabilities, which are the debts and bills the company pays.

Single-entry accounting only shows expenses and sales but doesn’t establish how those transactions determine profitability. In addition, errors are more likely to occur and be missed with single-entry accounting. Double-entry accounting provides checks and balances that catch clerical errors and fraud.

The Balance Sheet

The balance sheet is a financial statement that reflects the accounting equation formula. The balance sheet shows Assets in one section and liabilities and equity in another. The balance sheet breaks down assets and liabilities into categories or “accounts” and “subaccounts.“ The balances and transactions in these accounts tell a story about how the business is performing financially. 

 

Breaking Down the Components of the Accounting Equation

Since the balance sheet directly reflects the account equation in practice, the accounting equation breaks down into unique components.

Assets

Assets determine a company’s ability to operate. A typical asset is the company’s bank account.

Liabilities

Liabilities represent bills and debts incurred by the business to operate. Examples of liabilities are lease payments on equipment or office rent.

Equity

Equity shows the balance from all assets minus all liabilities. The difference between these two is the company’s value, which is eligible for equitable distribution to shareholders.

 

The 4 Different Arrangements of the Accounting Equation

Every business needs accounting, regardless of size, but the size determines how the accounting equation is arranged. Large companies use complex variations of the accounting equation.

Arrangement #1: The Basic/Fundamental Accounting Equation (Assets = Liabilities + Equity)

The basic accounting equation is the most commonly used arrangement. It is the most referenced in accounting courses and online by websites like NerdWallet.com and QuickBooks.com.

The fundamental accounting equation is used in startups and small to mid-sized companies with basic daily asset transactions like daily sales and periodic liabilities like rent and utility expenses.

Examples of the Fundamental Accounting Equation

1. ABC Hair Salon buys three hair dryer stations for $1,000 each. The accounting equation for this would look as follows:

$3000 Asset = $0 Liability + $3,000 Shareholders Equity.

1. ABC Hair Salon leases a suite in a high-rise business center. The lease payments are $4,000 per month for 12 months. The accounting equation for this would look as follows:

$48,000 Asset = $48,000 + $0 Shareholders equity.

1. ABC Hair Salon also sells hair care products. They have 1,000 units of shampoo in stock, each worth $10.00. The accounting equation for this would look as follows:

$10,000 Asset = $0 Liability + $10,000 Shareholders equity.

Arrangement # 2: Owner’s equity = Assets – Liabilities

If ABC Hair Salon wants to highlight owner’s equity, they may prefer an expansive version of the accounting equation. This version shows that a business has placed its creditors as a top priority against shareholders.

This expression reveals how the business’s obligations affect the owner’s equity.  This arrangement details how increasing or decreasing assets and liabilities affects shareholders’ equity.

Arrangement #3: Net Worth = Assets – Liabilities

This expansive version of the accounting equation is similar to arrangement number two because net worth is similar to owner’s equity. Net worth identifies a type of equity.

This arrangement shows the absolute bottom-line position for the shareholders. It differs from arrangement number two because equity can be categorized into subaccounts. Essentially, net worth is a by-product of all equity.

 

Importance of the Accounting Equation

The importance of the accounting equation cannot be understated. It is the key to accurate bookkeeping and a clear understanding of a business’s financial health. It also helps owners prove to investors that their business is a wise investment.

Businesses depend on the accounting equation to create financial statements and make critical financial projections. It helps business owners answer important financial questions and can be used to attract investors.

The balance sheet is the focal financial statement the accounting equation produces. It directly reflects the equation and how assets, liabilities, and equity accounts are organized.

 

Streamline Your Financial Reports

The accounting equation is simple and complex, all at the same time. It’s simple for small businesses with small transactions and complex for a large company with various assets and liabilities and several shareholders.

Companies can still manage their accounting manually, as before technological advances came along. However, there are ways to automate reporting and transaction recording using artificial intelligence tools and software.

Accounting systems can now record a transaction as soon as it happens in real-time and post it to the accounting ledger. Automate controls in an accounting system to ensure the integrity of the accounting equation remains with Divvy’s spend management solutions.