What is the Accounting Equation and Why it Matters

First-generation entrepreneurs who do not have much know-how about the financial concepts related to business should stop worrying & focus on capitalizing on their forte. It is important to have a basic know-how about the financial concepts when starting a business. Whether you are launching a tech startup that is using cutting-edge technologies like Machine Learning (ML), Artificial Intelligence (AI), etc. or working on a non-technical business idea, the fundamentals of business accounting remain the same. Owner’s Equity, Assets, and Liabilities are the three basic concepts related to financial accounting. The equation that connects all these three dots is called Accounting Equation.

What is Accounting Equation

Accounting Equation represents the relationship between Assets, Liabilities, and Owner’s Equity. It is the foundation of the double-entry principle. As per the double-entry principle, total debits equates to total credits for any type of financial transaction.

The expression of accounting equation which is most commonly used for the preparation of financial statements is:

Assets = Owner’s (Stockholder’s) Equity + Liabilities

Core Components of Accounting Equation

Let’s look into the core components that form the basis of the Accounting Equation:

  • Assets

Assets are the resources that have economic value or can create economic value. Liquid cash is considered a special form of asset. Assets like patents, copyrights, etc. are considered as intangible assets and assets like inventory, vehicles, cash, equipment, etc. are considered as tangible assets.

Assets = (Liabilities + Owner’s Equity)

  • Liabilities

Liabilities are the payments that your business needs to make. Some of the prime examples of liabilities are lease payments, payments on the lines of credit, loan payments, etc. It could be either short-term liability or long-term liability. Short-term liabilities are the business liabilities that are due within the next one year whereas long-term liabilities are the business liabilities that are due after one year from the current date.

Liabilities = (Assets – Owner’s Equity)

  • Equity held by the Owner (Stockholder)

Owner’s Equity is different from the value of the business. It refers to the percentage of the business that belongs to you.

Stockholder’s Equity = (Assets – Liabilities)

Accounting Equation in Practice

For demonstrating the usage of the Accounting Equation, let us take a hypothetical business scenario where:
Mr. Bizman, a sole proprietor has the following transactions in account books for 2019:

  • Jan 1 Invested Capital of 20,000 INR.
  • Jan 2 Purchased goods on credit from Marks & Co. for 2,000 INR.
  • Jan 4 Bought machinery for 8,000 INR on cash.
  • Jan 8 Purchased goods for 4,000 INR on cash.
  • Jan 12 Sold goods for (cost of inventory 4,000 + profit 2,000) 6,000 INR on cash
  • Jan 18 Paid to Marks & Co. in cash 1,000 INR
  • Jan 22 Received 300 INR from Mr. Deb (being a debtor)
  • Jan 25 Paid salary of 6,000 INR
  • Jan 30 Received interest of 5,000 INR
  • Jan 31 Paid wages of 3,000 INR

The effect of above transactions on Liabilities, Assets, and owner’s equity are shown below:

Date Transactions Assets = Liabilities + Owner’s Equity (Capital)
01.01.19 Capital brought into the business 20,000 20,000 20,000
02.01.19 Purchased goods on credit from Marks & Co., 2,000 + 2000 + 2,000
Revised equation 22,000 = 2000 + 20,000
04.01.19 Bought machinery for cash 8,000 +8,000
-8,000
– – – –
Revised equation 22,000 = 2000 + 20,000
08.01.19 Purchased goods for cash 4000 +4,000
-4,000
– – – –
Revised equation 22,000 = 2000 + 20,000
12.01.19 Sold goods for cash (cost of inventory 4,000 + Profit 2,000) 6000 +6,000
-4,000
– – +2,000
Revised equation 24,000 = 2000 + 22,000
18.01.19 Paid to Marks and Co., in cash 1,000 -1,000 -1,000
Revised equation 23,000 = 1000 + 22,000
22.01.19 Received from Mr. Deb 300 (being a debtor) -300
+300
– – – –
Revised equation 23,000 = 1000 + 22,000
25.01.19 Paid salary 6,000 -6,000 -6,000
Revised equation 17,000 = 1000 + 16,000
30.01.19 Received interest 5,000 +5,000 + 5,000
Revised equation 22,000 = 1000 + 21,000
31.01.19 Paid wages 3,000 -3,000 -3,000
Revised equation 19,000 = 1000 + 18,000

Accounting Methods

To keep a track of the financial transactions, it is necessary to follow an accounting method. Accounting method means that a timely financial record is created when income is accrued/ received or expenses are incurred/ paid.

Based on the scale and target customer segment of the business, you can choose from any of the three accounting methods:

  • Cash Accounting Method

As the name signifies, a transaction is recorded when money changes hands. Businesses where payment by customers is predominantly in cash make use of this accounting method.

  • Accrual Accounting Method

It is the most widely used accounting method. As per the accrual accounting method, gross income should be reported the moment it is earned. This means that record creation is not dependent on when the actual cash flow associated with the transaction occurs.

  • Hybrid Accounting Method

It is a combination of the Cash accounting method and the Accrual accounting method.

 

Conclusion

Accounting Equations can be one of the most important tools to access the financial health of the business. If your company has more liabilities than assets, you should rethink the way you manage your money!

FG Editorial Team
The Founder's Guide Team - Asian Associates with dynamic elements out to make a change.Thank you for visiting our site! If you do have any questions or inquiry, feel free to contact us through our links and please don't forget to follow our social media accounts. It would be our pleasure to help you in any way we can. Always Remember: "Proceed to Succeed". Hoping to hear from you soon!

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