February 1, 2021, Business
Accounting equation is also known as the balance sheet equation and provides the base for the whole accounting system. The equation is,
Assets = Liabilities + Equities
This means that for any business, its total assets are always equal to its liabilities plus total equities.
How it works?:-
Like any other equation, the accounting equation also keeps itself in balance!
Let us take one example:
Suppose the owner of the business invests $100,000 in the business. Here cash (asset) is increasing and at the same time common stock (equity) is also increasing. Both sides increased by the same amount, which is $100,000.
Assets = Liability + Equity
$100,000 = No change + $100,000
Now, let us take another example, where inventory worth $35,000 is purchased on account. Here Inventory ( asset) is increasing and since it is on account purchase, it will increase Accounts payables ( liability)
Asset = Liability + Equity
$35,000 = $35,000 + No change.
So, every time there is a transaction, there ought to be change in the accounting equation structure and still all the time equation is balanced!!
Why it is important?:-
Though the accounting equation is the very basic concept, it holds a vast importance in it simply because of the fact that this equation represents the balance sheet in itself. It is also noticeable that when the equation states that all of its assets are equal to summation of its liabilities and equities, it actually reveals the important fact that all the assets of the business are funded either by the Liabilities(outside debt) or by Equities (Owner’s portion of investment). And that makes the thing interesting,
That is how the right side of the equation plays a vital role in deciding the worth of business
Let us take two independent examples:-
Assets = $100
Liabilities = $30
Equities = $70
Here, we can see that,Assets = Liabilities + Equities
Both the sides of the equations are worth $100.
And we can say a company’s assets are funded more by the equity.
Assets = $100
Liabilities = $80
Equities = $20
In this case we see that both sides of the equations are still $100. But dynamics are changed here because the company’s assets are heavily debt funded.
So, with this example we understood why and how Accounting Equations are an important part of the Accounting World.