Accounting is a vital part of running a business. However, that does not show you have to be an accountant to study the basics. Component of the basics is learning how you spend for your assets. It is funded with debt or remunerated with capital. Use the accounting equation to recognise the difference. Let’s acknowledge a look.
Significance of Accounting Equation: The accounting equation is vital because it can furnish you with a fair understanding of your business’s financial position. It is the standard for financial reporting, and it is the justification for double-entry accounting. You cannot correctly read your balance sheet or know your financial statements with no balance sheet equation. In addition, your accounting equation serves to clarify questions like:
- Does the business have suitable assets to buy more equipment or new office space?
- Should you seek out a business loan (raise both liabilities and assets) to buy for your business?
- Do you have sufficient Revenue (assets) to pay your liabilities?
- The balance sheet equation explains major financial issues for your business. Drill the balance sheet equation when establishing your budget or when preparing monetary judgments.
Accounting Equation: Double-entry accounting supervises the accounting equation to discover the relationship among liabilities, assets, and Equity. When you receive the accounting equation, you can assume if you use business stocks to buy or finance them for debt. Therefore, the accounting equation is also called the balance sheet equation.
Equation of Expanded Accounting: The expanded accounting equation demonstrates the relationship between the balance sheet and the income statement. Revenue and owner contributions are the two principal sources that create Equity. The equation of comprehensive accounting is:
- Assets = Revenue + Liabilities + Owner’s Equity – Expenses – Draws
Wealth or Revenue is what your company makes through routine operations. Expenses are the charges to provide you with the services or products. Multiple transactions influence the owner’s Equity in the expanded accounting equation. For instance, Revenue raises the owner’s Equity, while the owner’s expenses, like rent payments and draws, lower the owner’s Equity. Both facets of the equation must match each other. If the expanded accounting equation is not equally approximated on both sides, your financial records are incorrect.
Expanded Accounting Equation
As you have acquired, the accounting equation of Assets = Liabilities + Equity is the basis of the double-entry accounting system. However, the way it is acted does not reflect the whole picture. To learn how this equation serves, we extend the equation to remember all of its parts. We attribute this as the “expanded” accounting equation:
- Assets = Liabilities + (Common Stock – Dividends + Revenues – Expenses)
This expanded equation needs into consideration the elements of Equity. Equity gains from revenues and owner investments (stock issuances) and drops from expenses and dividends. These equity relationships are conducted by expanding the accounting equation to incorporate debits and credits in double-entry form.
The progress (credits) to common stock and revenues grow Equity, whereas the gains (debits) to dividends and expenses lower Equity. Remember, the average balance of every account (asset, dividends, liability, common stock, Revenue, or cost) refers to the side where increases are recorded.
The expanded accounting equation can enable analysts to examine the company’s breakdown of shareholder’s Equity thoroughly. For instance, the revenues and expenses show the change in net income from period to period. In addition, stockholder transactions can be seen through contributed capital and dividends. Although these numbers are essential, they are still helpful for executives and interpreters to get a general conclusion of their trade.
Rearranged Expanded Accounting Equation
The expanded accounting equation can be reset to suit better the necessities of the individual practising it. We can rearrange the equation to be:
- Assets – Liabilities = Shareholder’s Equity
- Assets – Liabilities = Share Capital + Retained Earnings
- Assets – Liabilities = CC + BRE + R + E + D