accounting equation

accounting equation

Understanding the Accounting Equation

1. Introduction to the Accounting Equation

The concept of the accounting equation is that the records in a business fall into one of two categories: assets and claims. The assets are what the business owns. This includes items such as money, buildings, fixtures, and inventories. The claims are what the business owes, or if this money comes from creditors or the issuer of the bond, liabilities. Finally, the claim from the issuance of equity, as these funds come from the owner or stockholders. Put in another way, the business’s claim to any assets is part of the sum of the liabilities and the equity. It is important to emphasize here that both terms, I leave other things the same or, instinctively, the debit must be equal to the credit.”

“This equation is old because it was invented by Luca Pacioli (or Paciolo), who was a friend of Leonardo da Vinci and teacher of mathematics to King Charles VIII of France and his successor Louis XII. Pacioli was also a famous Franciscan monk and summarized all knowledge in his time in a book called The Summa. However, he has immortalized himself by his mathematical work, in which he describes the rule for negative numbers and the rule of false position for algebra, and described for the first time the Italian school of double-entry bookkeeping, which is still used to this day throughout the world.

The accounting equation, also known as the balance sheet equation, is a legal equation that is in every balance sheet. The accounting equation is expressed as:

2. Components of the Accounting Equation

The right hand side of the accounting equation is actually the sources of the assets of the entity used in its operations. Here we have marked that within the right hand side, we also mark the two components or sources of the assets in the entity, namely the Equity Capital portion and the Borrowed Funds portion. The equity capital is that portion which is brought in by the owners of the entity. The borrowed funds consist of diverse types of liabilities of the entity, of the amount expected to return within a year and the amount in long term of such funds. Every dollar so brought for financing of the assets and operations has a cost. Indeed, borrowed capital in the form of loan from the banks or other financial institutions would have terms attached. This is usually in the form of interest obligations.

In view of the above description of this equation, the components of the equation could be better appreciated. As noted above, the equation has two sides, namely the left hand side and the right hand side. The left hand side is actually the total assets of the entity. It tells us how the assets or resources of the entity are incorporated functionally with them so that they could generate the revenue of the entity. In fact, these assets are supported by both a part of the revenue generated by the entity and from the borrowed funds of the entity. Thus, this provides two sources of financing assets for the operations of these entities. These concepts are presented using the accounting equation of the entity.

3. Importance of the Accounting Equation

Accounting students will not be able to understand some of the important accounting concepts fully without the understanding of the accounting equation. Understanding some misconceptions (and confusions) in the accounting literature may be possible with the help of realizing the importance of the accounting equation. However, it must be noted that students need to understand that while the accounting equation is an invaluable accounting identity, it does not fulfill the complete meaning of assets, liabilities, and owners’ equity. Therefore, students should not misinterpret the accounting equation as defining assets, liabilities, and owners’ equity.

It is important to understand the accounting equation properly in view of its importance pervading the whole accounting system. For commercial firms, the combination of acquisitions of resources and the use of these resources to operate the business is of paramount importance. It enables the business to earn a profit and/or increase owners’ equity. This can be explained with the accounting equation. Some accounting concepts (both accounting identities and accounting principles) are related to the accounting equation. Knowledge of the accounting equation is important not only for the accounting student but also for decision makers, such as investors and creditors, who are interested in the financial performance and the financial position of the firm.

4. Examples and Applications of the Accounting Equation

To buy a car, one can use equity, sell bonds, or borrow from a commercial bank. But no matter what the source of the finance is, the change in the ownership of the car by the buyer in return for the finance received by the seller leads to an increase in the assets of the buyer and an increase of the equity of the seller. Accounting is the method of recording these increases and of regularly taking stock of the relative levels of the debt, the assets, and the equity of all economic units. The accuracy of the accounting record depends on the frequency with which stock is taken and how well the methodology used for measuring the value of assets, equities, and debts reflects the judgments and opinions of the economic units concerned. In the assessment of market prices, accounting emphasizes the sustainability of the price level associated with cash transactions.

A business using the accounting system described in the previous section will determine profit over a period of time, say a year, by preparing an income statement. Based on the experience of this period and the cash balance at the end of the period, it will form expectations about future income and expense and adjust its cash holdings accordingly. If, over the same period, it accumulates debt, buys a building, or issues new equity, it will be appropriate to refer to these changes in debt, assets, and equity using accounting terms. These terms refer to more than just cash; they are an attempt to describe the effects of all the changes in the business or household over the period. To see how an accounting system records changes in debt, assets, and equity, we look at examples 1 and 2.

5. Conclusion: Mastering the Accounting Equation

A controller is a financial navigator who has the responsibility to guide the captain (the manager) in controlling the financial grounds of the ship that is commanded by them. Thus, for all those who work in the area, it is paramount to master the accounting equation. It is a primary tool that allows people to interpret the current financial position and the global visualization which permits a deep understanding of the accounting process. In reiterating, the accounting equation is the bread meme of accounting; it has two slices: it is the great, elegant, and pioneering equation that conceals basic, comprehensive, and universal meanings. It is a primordial cause for the global, contemplating, and reasoning vision of the map of financial reality that allows navigators to understand the whole and the components that are considered the capital sources.

The accounting equation is the essence of the double-entry accounting system. It not only serves as a device, but also as a cornerstone that supports the financial edifice of a business organization. The complete value and meaning of the information contained in balance sheets, income statements, capital statements, and in all the information of the accounting and administrative systems, as well as the prospective information of the Planning and Control system, are predicated upon it. The need to understand thoroughly what the accounting equation represents and the various capital resources that embody the financial situation of an organization is vital, and this understanding will be a beacon that guides navigators through the innate complexities of the financial world.