The Accounting Equation is used by large corporations to all small business, and gives a financial position of the business – ie. its value (also known as equity), after debts/liabilities. The financial position is calculated from three items – assets (what it OWNS), liabilities (what is OWES) and equity (the difference between assets and liabilities or owner’s equity).
The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other.
The accounting equation for a sole proprietorship is:
Assets-Liabilities = Equity
It is also reported as:
Assets = Liabilities + Owner’s Equity
The accounting equation for a corporation is:
Assets = Liabilities + Stockholders’ Equity
Assets are the company’s resources – what the company owns of value. Examples are cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner’s (or stockholders’) equity.
Liabilities are the company’s obligations – what the company owes. Examples are notes or loans payable, accounts payable, salaries and wages payable, interest payable, superannuation and income and payroll taxes payable.
Owner’s equity or stockholders’ equity is the amount left over after liabilities are deducted from assets:
Assets – Liabilities = Owner’s (or Stockholders’) Equity.
Owner’s or stockholders’ equity also reports the amounts invested into the company by the owners plus the cumulative net profit/income of the company that has not been withdrawn or distributed to the owners.
With accurate records, the accounting equation will always be “in balance,” meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of the company’s accounts. As an example, if a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase (inventory) and one asset will decrease (bank paid for the stock). Because there are two or more accounts affected by every transaction, the accounting system is referred to as double entry accounting.
A company keeps track of all of its transactions by recording them in accounts in the company’s general ledger. Each account in the general ledger is designated as to its type: asset, liability, owner’s equity, sales/revenue, expense, profit or loss account.
Balance Sheet and Profit & Loss
The balance sheet is also known as the statement of financial position and it reflects the accounting equation. The balance sheet reports a company’s assets, liabilities, and owner’s (or stockholders’) equity at a specific point in time. Like the accounting equation, it shows that a company’s total amount of assets equals the total amount of liabilities plus owner’s (or stockholders’) equity.
The profit and loss or income statement is the financial statement that reports a company’s sales/revenues and expenses and the resulting net profit/income. While the balance sheet reports one point in time (the FINAL balance at a date), the profit & loss covers the total amount over a time interval or period of time (eg. a month). The profit and loss will explain part of the change in the owner’s or stockholders’ equity during the time interval between two balance sheets, as the profit or loss is reported on the balance sheet.
Understand the Profit & Loss and Margins (%) HERE
Learn why Profit does not equal Cash HERE
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