Accounting Equation: a Simple Explanation

Only after debts are settled are shareholders entitled to any of the company’s assets to attempt to recover their investment. The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet. It can be defined as the total number of dollars that a company would have left if it liquidated all of its assets and paid off all of its liabilities.

What Is a Liability in the Accounting Equation?

1. Thus, the accounting equation is an essential step in determining company profitability.
2. This transaction affects both sides of the accounting equation; both the left and right sides of the equation increase by +$250.
3. Metro Corporation collected a total of $5,000 on account from clients who owned money for services previously billed.
4. The most liquid of all assets, cash, appears on the first line of the balance sheet.
5. This matches their Total Assets on the left of the Accounting Equation.

An error in transaction analysis could result in incorrect financial statements. An accounting transaction is a business activity or event that causes a measurable change in the accounting equation. Merely placing an order for goods is not a recordable transaction because no exchange has taken place.

Put another way, it is the amount that would remain if the company liquidated all of its assets and paid off all of its debts. The remainder is the shareholders’ equity, which would be returned to them. The balance sheet is a very important financial statement for many reasons. It can be looked at on its own and in conjunction with other statements like the income statement and cash flow statement to get a full picture of a company’s health. The most liquid of all assets, cash, appears on the first line of the balance sheet.

This matches their Total Assets on the left of the Accounting Equation. The formula defines the relationship between a business’s Assets, Liabilities and Equity. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. In the below-given figure, we have shown the calculation of the balance sheet.

Download CFI’s Free Balance Sheet Template

After six months, Speakers, Inc. is growing rapidly and needs to find a new place of business. Ted decides it makes the most financial sense for Speakers, Inc. to buy a building. Since Speakers, Inc. doesn’t have $500,000 in cash to pay for a building, it must take out a loan. Speakers, Inc. purchases a $500,000 building by paying $100,000 in cash and taking out a $400,000 mortgage. This business transaction decreases assets by the $100,000 of cash disbursed, increases assets by the new $500,000 building, and increases liabilities by the new $400,000 mortgage. The asset equals the sum of all assets, i.e., cash, accounts receivable, prepaid expense, and inventory, i.e., $234,762 for 2014.

Balance Sheet Example

For example, if a company takes on a bank loan to be paid off in 5-years, this account will include the portion of that loan due in the next year. This line item includes all of the company’s intangible fixed assets, which may or may not be identifiable. Identifiable intangible assets include patents, licenses, and secret formulas. Balance sheets, like all financial statements, will have minor differences between organizations and industries. However, there are several “buckets” and line items that are almost always included in common balance sheets. We briefly go through commonly found line items under Current Assets, Long-Term Assets, Current Liabilities, Long-term Liabilities, and Equity.

These equations, entered in a business’s general ledger, will provide the material that eventually makes up the foundation of a business’s financial statements. This includes expense reports, cash flow and salary and company investments. The fundamental accounting equation, also called the balance sheet equation, is the foundation for the double-entry bookkeeping system and the cornerstone of the entire accounting science. In the accounting equation, every transaction will have a debit and credit entry, and the total debits (left side) will equal the total credits (right side).

This transaction affects both sides of the accounting equation; both the left and right sides of the equation increase by +$250. For every transaction, both sides of this equation must have an equal net effect. Below are some examples of transactions and how they affect the accounting equation. This equation sets the foundation of double-entry accounting, also known as double-entry bookkeeping, and highlights the structure of straight line depreciation example the balance sheet.

Some assets are tangible like cash while others are theoretical or intangible like goodwill or copyrights. Suppose a proprietor company has a liability of $1500, and owner equity is $2000. Calculation of Balance sheet, i.e., Total asset of a company will sum of liability and equity. Debt is a liability, whether it is a long-term loan or a bill that is due to be paid.

As a core concept in modern accounting, this provides the basis for keeping a company’s books balanced across a given accounting cycle. The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity. The accounting equation equates a company’s assets to what are the three types of personal accounts its liabilities and equity.