In the ever-evolving financial landscape, understanding its key elements is crucial to establishing a successful business. One such component of business finance is the Accounting equation and efficient accounting can make a difference in the overall business finance. Knowing the basic accounting formula is the key to managing the business accounting efficiently, as it gives an insight into your business's financial condition, enabling you to make informed decisions.
Understanding the intricacies of basic accounting helps you to navigate through the complex world of business finance management.
To take a deeper dive into it, we are here with this post. Let’s break down what the accounting equation is and how it works.
What is the Accounting Equation
The Accounting Equation is the foundation of accounting that summarizes the double-entry bookkeeping systems of a business's finances and is equal to the sum of its liabilities and equities of shareholders. Emphasizing the double-entry bookkeeping in which the debits are always equal to the credits and the assets equal to the sum of equities and liabilities, it establishes a relation between assets, liabilities, and owner’s equity in the business. The basic formula of the accounting equation is
Assets = Liabilities + Shareholders’ Equity
Aside from providing all the financial aspects, the Accounting equation reflects the relationship between the assets, liabilities, and capital of a business.
Understanding the Core Concepts of Accounting Eqation
To evaluate the exact financial condition of your business, you need to have a clear overview of the two core components of the balance sheet, Assets and Liabilities, along with the shareholders’ equity. The accounting equation lets you view the relation between these three key components, which helps you gauge the overall financial health of your organisation.
Key Components of Accounting Eqaution
Your business's financial accounting relies on the “accounting equation” or “Balance Sheet Equation”. Some Basic Accounting equations are
- Asset = Liability + Capital
- Liabilities = Assets - Capital
- Owners’ Equity (Capital) = Assets – Liabilities
Here is a brief overview of accounting equation assets liabilities
- Asset
An asset is a resource of an organization that has the potential to support the entity in current and future economic conditions. It comprises different kinds of assets like intangible assets, financial assets, fixed assets and current assets. Thus accounting equation states that all the assets owned by the business are either sponsored by the shareholder’s equity or the amount that a company owes to others, like suppliers or others.
Total Assets = Current Assets + Noncurrent Assets
Examples of Current Assets
- Cash
- Accounts receivable
- Stock inventory
- Prepaid liabilities
- Short-term investments (treasury bills, high-yield savings accounts and government bonds)
Examples of noncurrent assets
- Equipment
- Property or land
- Intellectual property
- Copyrights or trademarks
- Liabilities
Liabilities are the debts that a company owes to others, like partners or consumers. It comprises two components, current liabilities and noncurrent liabilities. The current liabilities mean your organization has to pay for them within the fiscal year, while the non-current liabilities are the amount that a company can pay over a longer period.
Liabilities = Assets – Shareholder’s Equity
Examples of current liabilities:
- Accounts payable
- Dividends
- Wages
- Income tax
- Short-term bank loans
- Notes payable
Examples of noncurrent liabilities:
- Bonds payable
- Retirement payments
- Debentures
- Deferred taxes
- Long-term loans
- Equity:
Equity or shareholders' equity is the amount of interests or residual interests that the owners and shareholders of the company will receive after paying off all the liabilities of the company.
Examples of equity:
- Retained earnings
- Preferred stock
- Common stock
- Paid-in capital
Wrap up
Thus, understanding the basic components of the accounting equation is very crucial for accounting professionals who use double-entry bookkeeping systems. It helps maintain the balance sheet of the firm accurately.
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