Are you a business owner who’s not a big fan of math? Unfortunately, running a business necessitates number crunching because you need to compute for profits and losses. And this is where the accounting equation comes in to ascertain the fiscal health of your operations. Without it, your company can fail, rendering all your efforts useless.
If you hate accounting, take comfort in knowing that you are not alone. Many other businessmen hate accounting, too. Fortunately, you can count on professional accountants to assist you. Let’s learn more about the accounting equation below and why it’s an important finance tool in managing your business:
What is the accounting equation?
The accounting equation is a representation of the relationship between assets, liabilities, and equity. It is the basis or foundation of the double-entry accounting system. It states that the total assets are equal to the sum of liabilities and shareholders’ equity.
You must record your business transactions in accordance with the accounting equation so each part of your journal entry is correct. This is to ensure that your balance sheet is balanced. Each entry that you make on the debit side should have a corresponding entry on the credit side. For this reason, you must implement proper bookkeeping and auditing practices.
The accounting equation formula is:
Assets = Liabilities + Shareholders’ Equity
What Do the Variables Mean?
Now, let’s find out what the different terms in the equations mean so you can better understand the its concepts.
Assets are the available resources that your company can use to produce positive economic value.
You can categorize total assets as either current assets or non-current assets. The current assets are assets that can be converted to cash within a year. Non-current or long-term assets, on the other hand, are assets that cannot be consumed or converted to cash within a year.
Some examples of assets include the following:
- Current Assets
- Cash and Cash equivalents
- Accounts receivable
- Prepaid expenses
- Office equipment
Liabilities are legally binding obligations that are payable to another entity. You can settle liabilities by transfer of money, goods, or services. It is increased with credit and decreased with debit.
Just like the total assets, total liabilities can be categorized as current liabilities and long-term liabilities. The current liabilities are debts that need to be paid within a year. Long-term liabilities, on the other hand, are obligations that are payable beyond one year. It is a liability that will not be paid in the current year or accounting period.
Some examples of liabilities include the following:
- Accounts Payable
- Accrued Liabilities
- Deferred Revenue
- Interest Payable
- Notes Payable
- Taxes Payable
- Salaries Payable
- Bonds Payable
3. Shareholders’ Equity
Shareholders’ equity is the representation of a company’s net worth. It is the amount that will be given to the shareholders after the total assets are liquidated and debts have been paid.
If the total assets are more than or exceed the total liabilities, you will have positive equity which means there are enough assets to cover the liabilities, If the total assets are less than the total liabilities, you will have negative equity which may indicate an impending bankruptcy.
Some examples of shareholders’ equity include the following:
- Common Sock
- Preferred Stock
- Additional Paid-in Capital
- Retained Earnings
What is the Importance of the Accounting Equation?
The accounting equation helps you verify whether or not your bookkeeping is accurate. After all, it is the foundation for double-entry accounting. The accounting equation will help you accurately read your company’s balance sheet and understand the financial statements of your business.
Just imagine, if you don’t have this at your disposal, you may be operating at a loss without knowing it. Perhaps, your company is doing well in terms of sales. But unbeknownst to you, you have more liabilities that you were unable to tally properly. Remember, it helps to know how well your business is doing financially.
This knowledge will help you determine the financial situation or financial health of your business. Are your total assets higher than your total liabilities? This may indicate that you are managing your finances well. If your total liabilities exceed your total assets, this may be an indication of your poor financial management or it could be issues with missing inventory or incorrect pricing.
Thus, the accounting equations is a vital guide that will help you in making financial decisions and future projections. If you need help with bookkeeping or accounting, don’t hesitate to give our team of CPAs a call. We can also help you audit your existing books. Our primary objective is to help you increase your assets and mitigate liabilities. Call us now for a free 30 minute consultation.