If you are a small business owner, you use the double-entry accounting system for bookkeeping, which is a method that involves recording each financial transaction twice. The accounting equation will have information about the assets of the company and must be equal to its liabilities and equity. The accounting equation depends on the double-entry system of accounting, where every transaction results in positive or negative changes to at least two of these accounts: assets, equity, or liabilities.
Accounting Equation:
The accounting equation shows the company’s assets, liability, and equity. Here assets are equal to liabilities plus equity.
You can find your company or business assets, liabilities, and equity on a few key financial statements, including the income statement and the balance sheet. This financial statement will give you a complete and quick overview of the financial position of the business or company. The accounting equation makes sure the balance sheet is balanced and shows transactions that are recorded accurately. When you use this accounting equation, you can know whether you use the business funds for your assets or finance them through debts. It is also called the balance sheet equation.
Components of balance sheet equation
Here are the components of the balance sheet equation used in the equation. A balance sheet is a financial statement that tracks all the financial ins and outs of your business. There are three types of balance sheet
Assets
Any items of value that your business or company owns are called assets. Your bank account and equipment-owned property are examples of assets. Leased items are not included in your assets.
Liabilities
Liabilities are debts that you owe to others. Business/ company credit cards, taxes, and rent to be paid are under liabilities. Taxes you have already paid do not come under your liabilities.
Equity
Your ownership in the business is equity. Sole proprietors hold entire ownership in the business/ company. If your company has multiple owners, your equity is divided among them all. Include the total value of any investments made by any equity stakeholders. To determine your company’s equity, subtract your entire assets from your total liabilities.
Accounting Equation Formula
The basic accounting equation formula is
Assets= liabilities + Equity
This concept can be expressed in several ways, such as
“equity = assets – liabilities,” but they all aim to achieve the same goal of accurately reporting transactions and balanced balance sheets. On the other hand, if assets do not equal liabilities + equity (or if the formula does not balance), a data processing or financial reporting error probably occurred.
Double-Entry Accounting System
A double-entry accounting system is used in the accounting equation. Every transaction in a double-entry accounting system has an impact on at least two accounts. For instance, if a business purchases a $1,000 piece of equipment on credit, the additional $1,000 increases both liabilities (the firm must pay it back) as well as assets.
These are the debit (DR) and credit (CR). A business loan will therefore raise obligations (credit), but it will also enhance assets and spending power (debit). In contrast, reducing liabilities—by paying off a debt or selling a piece of property—will have both a positive and a negative impact on assets: the value of the asset that is lost is subtracted, but the improvement in purchasing power is a positive asset change.
Importance of Accounting Equation
So now you understand how to use the accounting method and how it affects your books, let us move on.
Why is it crucial to your bookkeeping? The accounting equation is crucial because it may help you understand the financial condition of your company. It serves as both the foundation for double-entry accounting and the norm for financial reporting. You cannot correctly read your balance sheet or comprehend your financial accounts without the balance sheet equation.
Your accounting equation is useful in addressing issues like:
Do you have adequate assets to buy new workplace furniture or additional equipment?
Should you take out a business loan to fund purchases for your company, increasing both liabilities and assets?
The balance sheet equation provides important financial insights for your company/ business. When creating your budget or when making financial decisions, use the balance sheet calculation.
Benefits of Accounting Equation
The main benefit of using the accounting equation is that it provides an easy way to verify the accuracy of bookkeeping. Also, it helps in measuring the profitability of your business. If your liabilities are higher than your assets, it indicates managing your money well. On the other hand, if the equation balances, then your finances are on the right track.
You, as a business owner, will benefit from this information. If you decide to seek funding, a balanced accounting equation helps show whether an investment in your organization is a smart financial one, thus it is also helpful to prospective investors and lenders.
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