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What is the accounting equation?

What is the accounting equation?

The basic accounting equation at a glance

The accounting equation is so fundamental to accounting that it’s often the first concept taught in entry-level courses. It offers a quick, no-frills answer to keeping your assets versus liabilities in balance.

Here’s the formula: Assets = Liabilities + Equity

Because it considers assets, liabilities, and equity (also known as shareholders’ equity or owner’s equity), this basic accounting equation is the basis of a business’s balance sheet.

Your balance sheet is one of three financial statements. It’s a tool used by company leaders, investors, and analysts that better helps them understand the business’s financial health in terms of its assets versus liabilities and equity.

Why is the accounting equation important?

Although you can pull all the information you need to know about your current financial health from your balance sheet, it’s no easy feat to analyze a sheet full of sections, numbers, and various labeled accounts and subaccounts.

That’s where the accounting equation comes in.

This simple, easy-to-understand tool can tell you what you need to know upfront so you know what to focus on if there are any issues or room for improvement.

The relationship between the accounting equation and your balance sheet

The accounting equation focuses on your balance sheet, which is a historical summary of your company, what you own, and what you owe.

This straightforward relationship between assets, liabilities, and equity is the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the Debit side has a corresponding entry on the Credit side.

The financial position of any business, large or small, is based on two critical components of the balance sheet: Assets and liabilities. Owner’s equity, or shareholders’ equity, is the third section of the balance sheet.

The accounting equation represents how these three important components are associated with each other – and your balance sheet will help you understand your financial position.

An in-depth look into the accounting equation

While the accounting equation goes hand-in-hand with the balance sheet, it is also a fundamental aspect of the double-entry accounting system.

As its name implies, it records a business transaction twice: Once in the Debits and once in the Credits. Doing so shows that all components are the same in these separate accounts. This helps prevent errors and fraud and ensures balance, creating a more accurate picture of the company’s financial position.

Double entry accounting example

Almost all businesses use the double-entry accounting system because, truthfully, single-entry is outdated at this point. For example, if a business signs up for accounting software, it will automatically default to double-entry.

(A business might use single-entry bookkeeping if they rely on a spreadsheet, track expenses by hand, or print an end-of-the-year bank financial statement to total expenses.)

Still, let’s dive into the differences between the two so that you can understand how each might affect your bookkeeping process.

Single-entry vs. double-entry bookkeeping system

While single-entry accounting can help you kickstart your bookkeeping knowledge, it’s a dated process that many other business owners, investors, and banks won’t rely on. That’s why you’re better off starting with double-entry bookkeeping, even if you don’t do much reporting beyond a standard profit and loss statement.

In fact, most businesses don’t rely on single-entry accounting because they need more than what single-entry can provide. Single-entry accounting only shows expenses and sales but doesn’t establish how those transactions work together to determine profitability.

On the other hand, double-entry accounting records transactions in a way that demonstrates how profitable a company is becoming. Investors are interested in a business’s cash flow compared to its liability, which reflects current debts and bills.

Plus, errors are more likely to occur and be missed with single-entry accounting, whereas double-entry accounting provides checks and balances that catch clerical errors and fraud.

Breaking down the components of the accounting equation

Since the balance sheet is a direct reflection of the account equation in practice, the accounting equation breaks down into unique components:

  • Assets: An asset is anything a company owns that has current or future economic value. Assets include everything with monetary value controlled and owned by the company. For example, a company’s assets might include cash, accounts receivable, inventory, prepaid, patents, and fixed assets.
  • Liabilities: Liabilities represent anything the company owes or has borrowed from someone. An example of liability might include credit card payments, lease payments, or payroll liabilities owed to federal and state agencies.
  • Equity: Equity refers to a company’s book value, the difference between assets and liabilities on the balance sheet. Equity typically includes shareholder contributions, distributions, retained earnings, and net income.

The three arrangements of the accounting equation

Did you know that there are several names for this formula? Whether you call it the accounting equation, the accounting formula, the balance sheet equation, the fundamental accounting equation, or the basic accounting equation, they all mean the same thing.

This simple formula can also be expressed in three other ways, which we’ll cover next. At first glance, this may look overwhelming — but don’t worry because all three reveal the same information; it just depends on what kind of information you’re looking for.

Arrangement #1: Equity = Assets – Liabilities

This arrangement is used to highlight the creditors instead of the owners. So, if a creditor or lender wants to highlight the owner’s equity, this version helps paint a clearer picture if all assets are sold, and the funds are used to settle debts first. A lender will better understand if enough assets cover the potential debt.

Arrangement #2: Net Value = Assets – Liabilities

You might notice that this arrangement looks pretty similar to the E = A – L equation. That’s because it’s not uncommon for business owners and investors to refer to “net value” and “equity” as the same thing – and they are similar, but there are a couple of crucial differences.

Net value refers to the umbrella term that a company can keep after paying off all liabilities, also known as its book value. It specifically highlights the amount of ownership that the business owner(s) has.

On the other hand, equity refers to shareholder’s or owner’s equity, which is how much the shareholder or owner has staked into the company. Small business owners typically have a 100% stake in their company, while growing businesses may have an investor and share 20%.

Arrangement #3: Assets = Liabilities + Owner’s Capital – Owner’s Drawings + Revenues – Expenses

This long-form equation is called the expanded accounting equation.

Most sole proprietors aren’t going to know the knowledge or understanding of how to break down the equity sections (OC, OD, R, and E) like this unless they have a finance background. Still, you’ll likely see this equation pop up time and time again.

This arrangement can be ideal for sole proprietorships (usually unincorporated businesses owned by one person) in which there is no legal distinction between the owner and the business. For example, John Smith may own a landscaping company called John Smith’s Landscaping, where he performs most — if not all — the jobs.

This expanded accounting equation shows a deeper, more granular look into the relationship between all the business accounts. Investors would refer to this equation to foot the balance sheet and verify that the original equation – A = L + E – is accurate.

An alternative arrangement of the expanded accounting equation

Bookkeepers and business leaders can also write the expanded accounting equation like this:

Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Revenue – Expenses – Dividends

Both these arrangements mean the same thing – one just has fewer steps and may be easier to digest for those who aren’t yet familiar with the formula.

Streamline your financial reports with ease

This basic accounting equation formula is simple and complex all at the same time: It’s simple for small businesses with fewer business transactions and difficult for large companies with several assets, liabilities, and shareholders.

Before technological advances came along for these growing businesses, bookkeepers were forced to manually manage their accounting (when single-entry accounting was the norm). Of course, this lead to the chance of human error, which is detrimental to a company’s health, balance sheets, and investor ability.

That’s where BILL's automated expense software system comes in: Automate controls in your very own customized accounts payable and accounts receivable system to ensure that you’re always on the right track with a simple view of your company’s balance sheet with BILL Spend and Expense.

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