Accounting is an indispensable part of driving a business. However, that does not signify you have to be an accountant to learn the basics. Part of the basics is studying how you pay for your assets. It is financed with debt or compensated for with capital. Use the accounting equation to understand the difference. Let’s consider a look.
Accounting Equation: Double-entry accounting handles the accounting equation to determine the relationship among assets, liabilities, and equity. When you accept the accounting equation, you can understand if you use business stocks for your purchases or finance them for debt. The accounting equation is also termed the balance sheet equation.
Parts Of The Balance Sheet Equation: Your balance sheet is a financial statement that traces your company’s finances. There are three components to the balance sheet: assets, liabilities, and equity.
- Assets are any objects of value that your business owns. Your bank account, office equipment, company vehicles, and own property are examples of assets. Do not incorporate leased items in the assets.
- Liabilities are debts or payables that you owe to others. Business credit cards, rent, and taxes to be spent are all liabilities. Do not incorporate taxes you have previously paid in your liabilities.
- Equity shows your ownership of the business. Sole proprietors hold all of the rights in the company. If your company has more than one owner, you divide your equity between all the owners. Add the value of all investments from all the stakeholders in your equity as well. Deduct your total assets from the cumulative liabilities to determine your business equity.
Basics In the Balance Sheet Equation: In the basic accounting equation, liabilities and equity equal the total assets. The accounting formula is:
- Assets = Liabilities + Equity
Because you make purchases with debit or capital, both factions of the equation must equal. Equity has an equivalent effect on both sides of the equation. So, you can determine the third part of the equation if you comprehend the other two parts. You can also reproduce the accounting equation is:
- Liabilities = Assets – Equity
- Equity = Assets – Liabilities
Expanded Accounting Equation: The expanded accounting equation explains the relationship between the income statement and the balance sheet. Revenue and owner offerings are the two primary sources that generate equity. The extended accounting equation is:
- Assets = Liabilities + Revenue + Owner’s Equity – Expenses – Draws
Revenue is what your company gets through regular operations. Expenses are the costs to give you with the products or services. Various transactions impact the owner’s equity in the expanded accounting equation. For example, revenue increases the owner’s equity, while the owner’s draws and expenses, like rent payments, lower the owner’s equity. Both sides of the equation must match each other. If the expanded accounting equation is not balanced on both sides, your financial reports are false.
Importance of Accounting Equation The accounting equation is significant because it can give you a clear understanding of your business’s financial situation. It is the model for financial reporting, and it is the foundation for double-entry accounting. Without the balance sheet equation, you cannot correctly read your balance sheet or know your financial statements. In addition, your accounting equation serves to clarify questions like:
- Does the business have sufficient 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. Practice the balance sheet equation when establishing your budget or when preparing monetary judgments.