Knowing how to use equations in accounting can help you better understand the financial situation of your company. Regardless of your organization’s areas of activity, proper asset and liability tracking can have a direct impact on your success.
Knowing how to use equations in accounting is a valuable skill, but it requires research and practice.
In this article, we discuss the basic accounting equation, explain when to use it, what it includes, and give examples of how it should appear on balance sheets and income statements.
What is assets = liabilities + equity?
Assets = Liabilities + Equity is the basic accounting equation and the main element of the double-entry bookkeeping system. The double entry system records transactions as debits and credits.
Since each debit offsets a credit, the sum of all debits must equal the sum of all credits in any accurate double-entry system. The accounting equation is a tool used to ensure that the balance sheet maintains the balance between debits and credits.
Any organization, regardless of its size, uses two main components of the balance sheet: assets and liabilities. The third and final component of the basic accounting equation is equity, which represents full ownership of the business after all debts are paid.
The basic accounting equation represents the relationship between these three elements that define the financial situation of an organization.
Knowing how to use equations in accounting can help you better understand the financial situation of your company.
Regardless of your organization’s areas of activity, proper asset and liability tracking can have a direct impact on your success. Knowing how to use equations in accounting is a valuable skill, but it requires research and practice.
We will discuss the basic accounting equation, explain when to use it, what it includes, and give examples of how it should appear on balance sheets and income statements.
What is assets = liabilities + equity?
Assets = Liabilities + Equity is the basic accounting equation and the main element of the double-entry bookkeeping system. The double entry system records transactions as debits and credits.
Since each debit offsets a credit, the sum of all debits must equal the sum of all credits in any accurate double-entry system. The accounting equation is a tool used to ensure that the balance sheet maintains the balance between debits and credits.
Any organization, regardless of its size, uses two main components of the balance sheet: assets and liabilities. The third and final component of the basic accounting equation is equity, which represents full ownership of the business after all debts are paid.
The basic accounting equation represents the relationship between these three elements that define the financial situation of an organization.
What is included in assets = liabilities + equity
The main elements of the basic accounting equation are
Active
Assets are all of a company’s valuable possessions, such as land, buildings, equipment, and intellectual property. Depending on their exact nature, they can be divided into different types of assets:
- Accounts receivable: Any payments owed by customers to the company
- Inventory: All the merchandise that the company has in stock and that it intends to sell
- Cash: All money in the company’s bank account
- Equipment and property: All the physical assets the business needs to run its operations, such as tools, buildings, and land
There are usually two categories of assets:
- Current assets: Money and anything that can be converted into money within a year, such as inventory.
- Fixed Assets: Anything else that is harder to value and sell, such as intellectual property, land, or company brand equity.
Passives
Liabilities are all the debts of the company, such as unpaid bills, mortgages, bank loans and, in general, any sum of money that the company owes to another party. Some of the most frequent liabilities are
- Bank loans: Payment of any outstanding loans
- Accounts payable: The money the company owes its suppliers
- Wages and salaries to be paid: The wages and bonuses that the company has promised to pay to employees but has not yet done so
Generally, there are two categories of liability:
- Current liabilities: Debts due in 12 months
- Non-current liabilities: Debts that must be paid in a period of more than 12 months
Net worth
Net worth is the amount of value left after subtracting all of the company’s liabilities from its total assets. Smaller companies have it as owners’ equity on the balance sheet, while corporations have it as shareholders’ equity.
How to use assets = liabilities + net worth
In general, these are the main steps to calculate the basic accounting equation:
- Locate all current and noncurrent assets of the company on the balance sheet, for the period you are interested in.
- Locate all of the company’s current and non-current liabilities, as well as equity, and add the two figures together.
- Make sure that the total assets are equal to the sum between the total liabilities and the equity.
- Use the basic accounting equation formula to find the missing value of the three, if you know the other two.
Example of assets = liabilities + equity on a balance sheet
The balance sheet is one of the three main financial statements, the other two being the income statement and the statement of cash flows.
It offers a comprehensive view of a company’s assets, liabilities and net worth at any given time, helping owners and managers make decisions about the company’s financial future.
Here is an example of the basic accounting equation for a balance sheet:
| Montgomery Office Supply Company Balance Sheet | |||
| Active | Passives | Loans | Actions |
| Cash | $25,000 | $10,000 | $30,000 |
| Office Equipment Equity | $8000 | ||
| Office Furniture | $7000 | ||
| Total Assets | $40,000 | Total | $40,000 |
Conclusion
In business, accounting equations are essential for keeping track of finances and making sure that transactions are recorded accurately.
The three most common accounting equations are the equation of exchange, the equation of production, and the equation of budgeting.
The equation of exchange is used to determine how much money different items in a market will exchange for each other. The equation can be used to calculate the value of goods and services traded between two parties.
