The Accounting Equation?
The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company’s shareholders. It is the basis upon which the double entry accounting system is constructed.
The Accounting Equation shows that a company’s total amount of assets equals the total amount of liabilities plus owner’s (or stockholders’) equity.
Thus, the accounting equation is;
Assets = Liabilities + Shareholder Equity
The assets in the accounting equation are the resources that a company has available for its use, such as cash, accounts receivable, fixed assets, and inventory.
The Liabilities part of the equation is usually comprised of accounts payable that are owed to suppliers, a variety of accrued liabilities, such as sales taxes and income taxes, and debt payable to lenders.
The Shareholders’ Equity part of the equation is more complex than simply being the amount paid to the company by investors. It is actually their initial investment, plus any subsequent gains, minus any subsequent losses, minus any dividends or other withdrawals paid to the investors.
Every business transaction affects a company’s financial standing which is measured primarily based on assets, liabilities and owner’s equity or stockholders’ equity. The basic accounting equation is a simple way to show the relation between these three items.
KEY POINT: * The accounting equation demonstrates how business assets are financed*
THE ACCOUNTING EQUATION IN ANALYZING BUSINESS TRANSACTIONS
The accounting equation is at the root of transaction analysis in business. When a business executes any transaction: a sale to a customer, a purchase, a debt payment, a stock sale, the accounting equation must remain in balance. If the equation isn’t balanced, this indicates that the analysis is incomplete or incorrect.
If a transaction changes the total value on one side of the equation, the other side must change by an equal amount. The rules for financial accounting ensure that the equation will remain in balance.
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