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Accounting Equation Definition
An accounting equation, also known as a fundamental accounting equation or a balance sheet equation, is a principle of accounting that establishes a correlation between assets, liabilities and equity of an individual or a business entity. An accounting equation is a principal component of the double-entry accounting system and forms part of a balance sheet. The accounting equation states that the total assets of the individual or the business equals the sum of the liabilities and equity. In the case of an individual, the total assets equal the sum of liabilities and owner’s equity, whereas in the case of a company, the sum of assets equals the sum of liabilities and stockholders’ equity.
A Little More on Accounting Equation
Mathematically, an accounting equation can be represented as;
Assets = Liabilities + Equity.
A = L + E.
Assets = Liabilities + Owner’s Equity (for individuals or “sole proprietors”)
Assets = Liabilities + Stockholders’ Equity (for companies)
Let us now individually inspect the components of the accounting equation.
Assets: Assets typically consist of the following;
- Cash equivalents (liquid assets such as accounts receivable, treasury bills, securities, certificates of deposit and, in certain cases, precious metals)
Liabilities: Liabilities are what the sole proprietor or the company needs to pay in order to ensure the smooth functioning of the business. Liabilities typically include the following:
- All forms of debt
- Salaries and wages
- Dividends payable.
Owner’s Equity: Owner’s equity is calculated by subtracting the owner’s draws or withdrawals from the business from his/her investment in the business and then adding the net income (or subtracting the net loss) since the time of inception of the business.
Stockholders’ Equity: Stockholders’ equity is calculated by subtracting a company’s total liabilities from its total assets. So, in essence, stockholders’ equity is the sum of money that would be payable to shareholders in the event of a liquidation of all of the assets of the company as well as the paying off of all its debts.
Steps in an Accounting Equation
In any balance sheet, the total debits must be equal to the total credits. Therefore, an accounting equation mandates that any change to an asset account must be accompanied by an equal change to a related liability or equity account.
The accounting equation can be calculated by following these steps in the balance sheet;
- Calculating the total assets on the balance sheet for the period of consideration.
- Creating a separate list of the sum of all liabilities on the balance sheet.
- Calculating total owner’s equity or total shareholders’ equity.
- Adding up the sum of liabilities and the total owners/shareholders equity, which will equal the sum of the assets.
Importance of Accounting Equations
The accounting equation is essential since it enables an assessment of the accuracy of recording business transactions carried on by the individual or the company in all relevant books and accounts. This makes it possible to accurately assess the financial position of any business via its balance sheet.
Reference for “Accounting equation”
Academic research on “Accounting equation”
Reconciliation of net income to cash flow from operations: An accounting equation approach, Rai, A. (2003). Reconciliation of net income to cash flow from operations: An accounting equation approach. Journal of Accounting Education, 21(1), 17-24. This paper demonstrates the use of the basic accounting equation to provide the logic behind the steps commonly described in current accounting textbooks to reconcile net income to cash flow from operating activities. Such a framework provides students a better understanding of the indirect method of calculating cash flow from operating activities. A step-by-step analysis is provided to demonstrate how cash flow can be obtained using the basic accounting equation. The analysis provided in this paper also highlights the articulation of financial statements.
Using accounting equation analysis to teach the statement of cash flows in the first financial accounting course, O’Bryan, D., Berry, K. T., Troutman, C., & Quirin, J. J. (2000). Using accounting equation analysis to teach the statement of cash flows in the first financial accounting course. Journal of Accounting Education, 18(2), 147-155. Understanding the statement of cash flows requires that students have some knowledge of accrual-basis accounting. This means that coverage of the statement of cash flows is deferred until late in the introductory financial accounting course and related textbooks, a time when student motivation and retention may be waning. The timing of statement of cash flow coverage is unfortunate for two reasons. First, the statement of cash flows is an important topic that all business students need to understand. Second, most students understand cash flows at the start of their financial accounting class, so there is no reason to defer coverage of this topic. This paper describes a user-oriented, pedagogical approach to integrating the statement of cash flows throughout the first financial accounting course. The essence of this approach is the use of an expanded accounting equation with temporary cash accounts corresponding to the major categories on the statement of cash flows. Directly capturing cash flow information simplifies the preparation of the statement of cash flows.
A field experiment examining the effects of accounting equation emphasis and transaction scope on students learning to journalize, Phillips, F., & Heiser, L. (2011). A field experiment examining the effects of accounting equation emphasis and transaction scope on students learning to journalize. Issues in Accounting Education, 26(4), 681-699. Financial accounting textbooks introduce the journalizing process in varying ways. Some texts emphasize the accounting equation, others do not. Some begin with a restricted set of transactions affecting only balance sheet accounts, whereas others begin with an expanded set of transactions affecting both balance sheet and income statement accounts. Based on Scaffolding Theory, we examine the potential effects of these variations on student learning. We conducted a field experiment that randomly assigned students to one of six learning conditions that varied the requirement to document accounting equation effects (before or after each journal entry, or not at all) and the scope of transactions (restricted versus expanded). Analyses indicated that students were initially more successful in journalizing transactions if they explicitly considered accounting equation effects, but these benefits faded over a one-week period. Also, students initially introduced to a restricted scope of transactions were more successful in journalizing transactions that involved balance sheet accounts. These immediate benefits assisted students later when journalizing more complex transactions involving balance sheet and income statement accounts; improved initial instruction compensated for less practice with more complex material.
The accounting equation inequality: A set theory approach, Juárez, F. (2015). The accounting equation inequality: A set theory approach. Global Journal of Business Research, 9(3), 97-104. The basics of financial accounting in the balance sheet and the accounting equation are revisited from the viewpoint of axiomatic set theory and predicate logic. The conceptual distinction between assets and claims on the assets are pointed out; next, it follows an application of the axioms of the theory. By a combination of axioms, this application leads to obtain two sets of capital units, which contains assets and claims (Liabilities plus Owners’ Equity) on the assets, respectively. These sets are properly built, according to the use of the axioms; they contain all the lowest level items of the financial statements that still have financial meaning in the balance sheet. An analysis of the equality between these sets was applied to test the equality of the assets to the union of liabilities and equity. The analysis determined that these sets were not equal and as a conclusion assets are not equal to liabilities plus equity. This inequality is interpreted within the restrictions of the application of the set theory to financial data and algebraic sum. Nevertheless, the particular case where the accounting equation holds is described; however, this case has no financial meaning.
Introducing the Accounting Equation with M&M’s®., Scofield, B. W., & Dye, W. (2009). Introducing the Accounting Equation with M&M’s®. American Journal of Business Education, 2(7), 127-138.
The Dual Aspects of Accounting Transactions and Asset Value Change in the Accounting Equation, Juarez, F. (2016). The Dual Aspects of Accounting Transactions and Asset Value Change in the Accounting Equation. International Journal of Economics and Management Systems, 1. The purpose of the study is to analyze the accounting equation and the relation between assets and claims on the assets (liabilities plus stockholders’ equity), based on the dual aspects of accounting transactions. The methodology is rationalistic and analytical. The analysis consists of the application of the identity and characteristic functions, as well as a coordinate transformation. Results show that the accounting equation does not consist in a single addition, what would lead to inequality, but a series of addition functions when taking into account the dual aspects of accounting transactions. Due to the different number of summation dimensions on each side of the final equation, a coordinate transformation is applied resulting in a change in the value of assets; this value is not the same as that of the initial accounting equation.