Definition, Explanation and Examples

The income and retained earnings of the accounting equation is also an essential component in computing, understanding, and analyzing a firm’s income statement. This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly.

From the accounting consignor and consignee equation, we see that the amount of assets must equal the combined amount of liabilities plus owner’s (or stockholders’) equity. The accounting equation is based on the premise that the sum of a company’s assets is equal to its total liabilities and shareholders’ equity. As a core concept in modern accounting, this provides the basis for keeping a company’s books balanced across a given accounting cycle.

Example Transaction #3: Purchase of Supplies on Credit

The claims to the assets owned by a business entity are primarily divided into two types – the claims of creditors and the claims of owner of the business. In accounting, the claims of creditors are referred to as liabilities and the claims of owner are referred to as owner’s equity. Now that you are familiar with some basic concepts of the accounting equation and balance sheet let’s explore some practice examples you can try for yourself. In accounting, we have different classifications of assets and liabilities because we need to determine how we report them on the balance sheet.

Often, a company may depreciate capital assets in 5–7 years, meaning that the assets will show on the books as less than their “real” value, or what they would be worth on the secondary market. The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left-side value of the equation will always match the right-side value. The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet. Let’s move ahead so that you can gain a more detailed understanding of the basic accounting equation and its components. The Accounting Equation is a vital formula to understand and consider when it comes to the financial health of your business. The accounting equation is a factor in almost every aspect of your business accounting.

Balance Sheet and Income Statement

This transaction affects both sides of the accounting equation; both the left and right sides of the equation increase by +$250. This transaction affects only the assets of the equation; therefore there is no corresponding effect in liabilities or shareholder’s equity on the right side of the equation. Apple pays for rent ($600) and utilities ($200) expenses for a total of $800 in cash. Non-current assets or liabilities are those that cannot be converted easily into cash, typically within a year, that is. Current assets and liabilities can be converted into cash within one year.

The accounting equation states that the amount of assets must be equal to liabilities plus shareholder or owner equity. An error in transaction analysis could result in incorrect financial statements. Owners can increase their ownership share by contributing money to the company or decrease equity by withdrawing company funds. As you can see, assets equal the sum of liabilities and owner’s equity.

If a company keeps accurate records using the double-entry system, the accounting equation will always be “in balance,” meaning the left side of the equation will be equal to the right side. The balance is maintained because every business transaction affects at least two of a company’s accounts. For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as the double-entry accounting or bookkeeping system. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill.

To make the Accounting Equation topic even easier to understand, we created a collection of premium materials called AccountingCoach PRO. Our PRO users get lifetime access to our accounting equation visual tutorial, cheat sheet, flashcards, quick test, and more. The accounting equation is fundamental to the double-entry bookkeeping practice. This number is the sum of total earnings that were not paid to shareholders as dividends.

1. Thus, all of the company’s assets stem from either creditors or investors i.e. liabilities and equity.
2. The accounting equation is based on the premise that the sum of a company’s assets is equal to its total liabilities and shareholders’ equity.
3. Only after debts are settled are shareholders entitled to any of the company’s assets to attempt to recover their investment.
4. Journal entries often use the language of debits (DR) and credits (CR).

Classification of Assets and Liabilities

Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. Debt is a liability, whether it is a long-term loan or a bill that is due to be paid.

The accounting equation plays a significant role as the foundation of the double-entry bookkeeping system. It is used to transfer totals from books of prime entry into the nominal ledger. Every transaction is recorded twice so that the debit is balanced by a credit. The accounting equation helps to assess whether the business transactions carried out by the company are being accurately reflected in its books and accounts.

The CFS shows money going into (cash inflow) and out of (cash outflow) a business; it is furthermore separated into operating, investing, and financing activities. To learn more about the balance sheet, see our Balance Sheet Outline. The global adherence to the double-entry accounting system makes the account-keeping and -tallying processes more standardized and foolproof. Think of retained earnings as savings, since it represents the total profits what is creditors turnover ratio that have been saved and put aside (or “retained”) for future use. Accounts receivable list the amounts of money owed to the company by its customers for the sale of its products. Metro issued a check to Rent Commerce, Inc. for $1,800 to pay for office rent in advance for the months of February and March.

This business transaction increases company cash and increases equity by the same amount. The accounting equation is also called the basic accounting equation or the balance sheet equation. In this form, it is easier to highlight the relationship between shareholder’s equity and debt (liabilities). As you can see, shareholder’s equity is the remainder after liabilities have been subtracted from assets. This is because creditors – parties that lend money such as banks – have the first claim to a company’s assets. The revenue a company shareholder can claim after debts have been paid is Shareholder Equity.

Module 1: The Role of Accounting in Business

Equity represents the portion of company assets that shareholders or partners own. In other words, the shareholders or partners own the remainder of assets once all of the liabilities are paid off. Receivables arise when a company provides a service or sells a product to someone on credit. These are some simple examples, but even the most complicated transactions can be recorded in a similar way. For example, if a company becomes bankrupt, its assets are sold and these funds are used to settle its debts first. Only after debts are settled are shareholders entitled to any of the company’s assets to attempt to recover their investment.

After six months, Speakers, Inc. is growing rapidly and needs to find a new place of business. Ted decides it makes the most financial sense for Speakers, Inc. to buy a building. Since Speakers, Inc. doesn’t have $500,000 in cash to pay for a building, it must take out a loan. Speakers, Inc. purchases a $500,000 building by paying $100,000 in cash and taking out a $400,000 mortgage.

Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting. Shareholder Equity is equal to a business’s total assets minus its total liabilities. It can be found on a balance sheet and is one of the most important metrics for analysts to assess the financial health of a company.