What is the Accounting Equation Formula: Basic Examples

Accounting is essential to any business, regardless of size, fund, structure, and industry. The accounting equation, also known as the balance sheet equation, calculates the relationship between the assets, liabilities, and owner's equity. Moreover, the basic accounting equation estimates the financial reports and learns about a company’s financial health. The equation is also the foundation of the double-entry accounting system.

Organisation use their balance sheet to calculate the accounting equation. This shows that their financial statements are balanced and the double-entry accounting system functions. The company's assets are the same as its debts and equity. In this article, we will do our best to explain the definition of an accounting equation to you. Furthermore, we show formulas for how to calculate basic accounting equations.

What is Accounting Equation

The accounting equation is the basis of the double-entry bookkeeping method, which most organizations use to ensure their balance sheet is always equal. The left side of the sheet representing the resources should match the right side. But Before we elaborate, let’s understand the definition of the basic accounting equation.

Definition

As discussed earlier, the accounting equation defines the connection between a company’s assets, liabilities, and owner's equity. Moving next, assets are everything a business owns, while everything the business owes is liabilities. On the other hand, the owner’s equity is the owner’s share of the total assets.

By basic accounting rules, the left side of the balance sheet (debts) should equal the right side (what the company owns). Interestingly, the business owner is doing well if what the company owns matches its debts. Furthermore, the financial accounting equation is double-entry, where the total debits match every transaction’s full credits.

Elements In The Accounting Equation Formula

Three primary indicators are used to evaluate a business's financial position. This can be summarized by using these formulae:

Assets – Liabilities = Owner’s Equity

$500,000 – $100,000 = $400,000

Liabilities + Owner’s Equity = Assets

$100,000 + $ 800,000 = $900,000

Before we delve deeper into accounting equation problems, let’s understand the fundamental accounting equation: assets, liabilities, and owner’s equity.

Assets

Assets are resources owned by businesses used for production and sales. Examples of assets include cash, inventory of product assets, and accounts receivable. Moreover, material assets like customer supplies, office supplies, dishes, computer appliances, land, furniture, buildings, billing, and collection systems. Intangible assets consist of copyrights, trademarks, patents, etc.

People who invest in or lend money to a business have a claim on the business's stuff. For example, if someone lends money to a business owner, they have a legal right to some of the business's things until the money is paid back.

Liabilities

Liabilities are what businesses owe to their lenders and other third parties. Creditors are people or organizations that a business owes money to. This could be employees, banks, or even government agencies, just like how a business's possessions (assets) can be divided into current assets (things they plan to use or sell soon) and fixed assets (things they’ll keep for a long time), the money a business owes (liabilities) can also be divided similarly. Current liabilities are money that a business needs to pay soon. This includes things like salaries for employees, bills for utilities, and payments for supplies. Long-term liabilities are money a business will pay back over an extended period. This includes things like mortgages, taxes that have been delayed, and loans from banks.

Owner’s Equity

As stated before, the owner’s equity represents the value of assets. To be more precise, it’s the remaining amount after all assets have been sold and all debts have been settled. Let's delve into the factors that lead to a rise or fall in owner's equity.

Rise In The Owner’s Equity

There are two examples when the owner’s equity increases: revenue and additional investment. Owner Investments into their firm, which is know as the owner’s finances on the balance sheet. On the other hand, revenue is the total profit from sales, lending cash, commissions, and renting.

Extended Accounting Equation

The accounting extended comprises the following elements:

  • Assets
  • Liabilities
  • Owner’s funds
  • Owner’s drawings
  • Revenues
  • Charges

So, the formula will be

Assets = Liabilities + Owner’s Funds – Owner’s Drawings + Revenues – Charges

However, the formulation gives a complete idea of the relationship between a business's central financial transaction records. You can arrange and rearrange this into other forms to solve accounting equation problems.

Owner’s Equity = Net Assets – Liabilities

There is not a big difference; the entire meaning will change if you shift the owner's equity to the left-hand side. It proposes creditors priority over owners for meeting their demands. Furthermore, the equation's primary goal is to analyze a business's investments, credit, charges, bank loan profit, accounts payable liability, etc.

Net Worth = Assets – Liabilities

It is synonymous with owner's equity and follows the same equation. Another word for owner's equity is known as stockholder’s equity. The expanded accounting equation is also formulated as the following:

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

How To Solve A Basic Accounting Equation?

Let's check out some examples of accounting equations and their solutions to grasp the calculations better.

Example 1

Using the accounting equation transaction formula, determine the missing factor:

Assets = $100,000 Liabilities = $20,000 Equity =?

Solution

Equity = Assets – Liabilities = $100,000 – $20,000 = $80,000

Example 2

Using the accounting equation transaction formula, determine the missing factor:

Assets = $120,000 Liabilities =? Equity = $80,000

Solution

Liabilities = Assets – Equity = $120,000 – $80,000 = $40,000

Example 3

Using the accounting equation transaction formula, determine the missing factor:

Assets =?

Liabilities + Equity = $400,000

Solution

Assets = Liabilities + Equity = $400,000

Types Of Accounting Problems

Accounting problems lead to severe mistakes in financial reports and unnoticed errors. These create weak internal management, wrong use of standard accounting rules (GAAP), online security issues, and not following regulations. If these accounting problems are addressed, they can lead to positive cash flow and correct reporting of how profitable a business is. Here are some typical accounting problems that companies often face:

  • Payroll errors
  • Revenue recognition
  • Missing impairment write-downs
  • Lease accounting
  • Cash flow statement
  • Insufficient financial analysis
  • Outdated accounting software technology
  • Fraudulent activities
  • Inadequate internal control
  • Poor security measures
  • Regulatory non-compliance

Accounting Equation Limitations

The accounting equation, however, plays an important role in making a connection between the three elements: asset, liability, and equity. But it's only sometimes suitable for learning financial transactions, investments, funds, bank debts, debit, and high credit: business loans and other finance-linked information.

Additionally, sometimes there’s no guarantee of a correct answer even if you find debits equal credit transactions. Lots of errors may not even involve accounting equations. People with a financial interest in the company must carefully check the results. See if the company has enough resources and credit, or too much, to ensure a new business can grow in the long term. Suppose you want to understand more about the problems with accounting equations, issues with credit accounts, and the impact of a bank loan. And how do you balance the cost of inventory and money on the balance sheet? You can reach out to an accounting expert for assistance.

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