What Is the Accounting Equation, Its Purpose and How Do You Calculate It?

Introduction

While the financial landscape continues to evolve and undergo dynamic changes, a key foundational element that continues to guide accounting processes across industries is the accounting equation. Acting as the cornerstone for financial statements, it holds the key in enabling us to understand the financial health of an organization. 

Whether you are a business owner or a part of the CFO office it is of paramount importance to understand the complexities of the accounting equation to seamlessly navigate through the intricacies involved in fiscal management. In this article, we take a deep dive to understand the core attributes of the accounting equation, its role in day to day transactions and how it plays a crucial role in accurate financial reporting. 

What Is the Accounting Equation?

The accounting equation represents a fundamental principle of accounting that states that a company’s total assets are equal to the sum of its liabilities and equity. It forms the basis of double-entry accounting, where every transaction results in a dual effect, ensuring balance sheet accuracy.

Understanding the Core Components of the Accounting Equation

To fully comprehend the economic positioning of any organization across any industry one needs to have a clear overview of two core components outlined in the balance sheet: assets and liabilities. The third core component of the balance sheet is shareholder’s equity.The accounting equation enables us to see the interconnectedness between these three key components that is pivotal to gauge financial standing of an organization. 

What are assets?

An asset is a resource that can provide current or future economic benefit to the organization who owns or controls the asset. Assets are reported on a company’s balance sheet and comprises various asset types such as intangible assets, financial assets, fixed assets and current assets. 

Examples of assets 

• Cash and cash equivalents 
• Inventory 
• Accounts receivables 
• Building
• Equipments/Machinery 
• Land
• Securities and bonds 
• Patents 
• Royalties 
• Intellectual property
• Brand equity
• Copyright
• Trademarks

Here we can see the list of all assets that have been reported on Hershey company balance sheet for 2023. 

Source

How to calculate assets in accounting?

In order to calculate assets in accounting organizations need to follow these steps

• Organizations should list down all the assets that the company owns or controls. This includes both tangible and intangible assets. 
• Once they have listed down all the assets they need to prepare a balance sheet adhering to the double entry accounting system. The assets need to be categorized into fixed, current, intangible and financial sheets and added to the sheet.
• Next organizations need to take a sum of all the assets listed in the balance sheet.

If the total assets calculated equals the sum of liabilities and equity then an organization has correctly gauged the value of all three key components. However, if this does not match then organizations need to check for discrepancies. Utilizing advanced accounting software enables organizations to proactively identify and manage anomalies. 

What are liabilities?

Liabilities are financial obligations or debts that a company owes to other entities. Liabilities are an essential component for an organization to ensure smooth business operations.They are recorded in the balance sheet and are categorized as current and long-term liabilities based on their due date. 

Example of liabilities 

• Accounts payables 
• Deferred revenue 
• Short-term loans 
• Long-term loans 
• Income tax payables 
• Mortgage
• Lease

Here we can see the list of all liabilities that have been reported on Hershey company balance sheet for 2023.

How to calculate liabilities in accounting?

In order to calculate liabilities in accounting organizations need to follow these steps

• Organizations should list down all the debts and financial obligations that they owe. This includes both current and long term liabilities.
• Once they have listed down all the liabilities they need to prepare a balance sheet adhering to the double entry accounting system. The liabilities need to be categorized into current and long-term based on their due date. 
• Next organizations need to take a sum of all the liabilities listed in the balance sheet.

If the total liabilities calculated equals the difference between assets and equity then an organization has correctly gauged the value of all three key components. However, if this does not match then organizations need to check for discrepancies.

What is equity?

Equity denotes the value or ownership interest on residual assets that an organization’s owner or shareholders would receive if all liabilities were paid. It is an important financial statement that is a key component of the balance sheet. It is an important parameter to gauge a firm’s financial health.

Example of equity

• Retained earnings 
• Capital contribution
• Common stock 
• Additional paid-in capital
• Treasury stock
• Accumulated other income/loss

How to calculate equity in accounting?

The equity accounting formula can be derived from the accounting equation and expressed as

Firms can get the data for total assets and total liabilities from the balance sheet which they can then use further in the accounting equation to determine the equity. 

For example referring to Hershey company balance sheet for 2023

Total assets = $ 11902941

Total liabilities = $ 7803855

Equity = Assets – Liabilities 

Hershey Equity = 11902941- 7803855 = $ 4099086

Who Uses the Accounting Equation?

The accounting equation in accounting holds fundamental importance and is utilized by different stakeholders to understand the financial health and position of a company. Some of the major stakeholders that utilize accounting equation are: 

• Future Investments Decisions: They utilize the accounting equation to determine the financial health of the organization and accordingly decide on future investment decisions.
• Accountants: Accountants are the major stakeholders who use the accounting equation to check if they have correctly recorded all the transactions and identify if there are any discrepancies. 
• Auditors: Auditors utilize the accounting equation while they are auditing the organizations financial statements and reports to ascertain if transactions are correctly recorded. 
• Creditors: Creditors utilize the accounting equation to gauge the creditworthiness of the business prior to deciding on credit related decisions. 
• Founders and business owners: They often utilize the accounting equation to gauge the financial health of the organization, take strategic decisions and plan for the future. 
• Analysts and Advisors: Analysts leverage the accounting equation to analyze the financial statements of the business, gauge the performance and valuation of the business and offer specific recommendations to their clients. 

Double-entry system and its significance

Double-entry system is the foundation of bookkeeping, where each transaction has a dual effect and impacts two accounts: where one account is debited, and the other account is credited. This method adheres to the principle that the total debit amount must always match the total credit amount. It is based on the principle that for every debit entry, there must be a corresponding credit entry, ensuring that the accounting equation (Assets = Liabilities + Equity) is always in balance.

Any discrepancies between recorded assets and the sum of equity and liabilities signal an anomaly and a need for corrections in account balances. The brilliance of the double-entry system lies in its self-balancing mechanism, acting as a check-and-balance system to reduce errors and uphold financial data integrity. Double entry system ensures accuracy and completeness in its accounting system. This methodical approach is fundamental to the accounting system’s integrity.

Limitations of Accounting Equation

While the accounting equation is foundational to accounting processes it has some limitations. These are: 

• Provides a stagnant overview: The accounting equation provides a static overview and does not provide any visibility into dynamic financial activities or cash flows over the reporting period. It does not consider any market or non monetary changes that will impact the financial health and position of the organization. 
• Provides a simplified overview: The accounting equation oversimplifies an organization’s financial health and position, as it does not showcase a true assessment of the assets quality or the nature of the liabilities.
• Does not showcase the true economic value: Accounting equation utilizes the book values rather than current market values. Owing to this the actual value of assets and liabilities is not accurate. 
• Does not consider the time value of money: The accounting equation does not consider the time value of money as well as factors such as inflation. So apart from using the accounting equation, business owners and investors need to factor in these aspects and analyze them prior to making any strategic decisions.
• Lack of insights: As revenue and expense details are not included in the accounting equation there is a lack of overview regarding profitability, productivity and efficiency. .
• Lack of risk related overview: The accounting equation does not reflect the nature of assets and liabilities and stakeholders are unable to gauge on aspects such as asset depreciation, quality of assets, bad debts. 
• Requires further analysis: Business owners, investors and other stakeholders cannot solely rely on accounting equations as it provides a stagnant overview and does not provide any interpretation with respect to the numbers. Stakeholders need to undertake further analysis to determine the actual financial health of the organization. 

Real World Accounting Equation Example

To see a live example of how the accounting equation works let us utilize the 3M 2023 Annual Report. 

For 2023, 3M financial statements reflects (values in dollars in millions) 

Total assets: $ 50, 580

Total liabilities: $ 45,712

Equity: $ 4,868

Now using the accounting equation 

 Assets = Liabilities + Equity 

50580 (assets) = 45712 (liabilities) + 4868 (equity) 

Here we see that the sum of liabilities and equity equals the total assets and the equation balances.

How HighRadius Can Help?

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At the heart of HighRadius’s R2R solution is an AI-powered platform designed to cater to all accounting roles. One of the standout features of the solution is its ability to automate almost 50% of manual repetitive tasks. This is achieved through LiveCube, a ‘No Code’ platform, that replaces Excel and automates data fetching, modeling, analysis, and journal entry proposals. It empowers the accounting teams as any stakeholder who is familiar with tools like Excel or Google Sheets, can rapidly build applications without relying on IT, significantly enhancing the automation of accounting calculations.

HighRadius Solution empowers organizations to experience enhanced efficiency by leveraging the best of the latest accounting technology. The R2R solution not only provides organizations with a powerful, AI-driven platform that enhances efficiency and accuracy but also fundamentally changes the way organizations approach and execute their accounting processes.

FAQs

1) Which financial statement involves all aspects of the accounting equation?

Balance sheet is the financial statement that involves all aspects of the accounting equation namely, assets, liabilities and equity. A balance sheet provides accurate information regarding an organization’s financial position at a specific point related to its reporting period. 

2) Why is accounting equation important?

The accounting equation is important as it lays the foundation of accounting and the double-entry system. It ensures accuracy in recording financial transactions and ensures that the balance sheet is balanced. It provides stakeholders an effective way to analyze the financial position of the firm.

3) What is the purpose of the accounting equation?

The purpose of the accounting equation is that it lays the framework for the accounting processes and ensures integrity in financial transaction recording. It plays a crucial role in preparing financial statements that enables analyzing a firm’s financial health while ensuring transparency in accounting processes. 

4) What is the fundamental accounting equation?

The fundamental accounting equation states that an organization’s total assets is equivalent to the sum of its liabilities and equity. It is represented as Assets= Liabilities + Equity. The accounting equation showcases the relation between assets, liabilities and shareholder’s equity. 

5) How to show the effect of transactions on an accounting equation?

To show the effect of transactions on an accounting equation, first the transactions need to be categorized, next using the double entry system the transactions need to be recorded in the accounts that it impacts, next the new account balance needs to be calculated post which one needs to check if the accounting equation is balanced. If the equation is balanced then the financial statement can be prepared. 

6) Which businesses use an accounting equation?

The accounting equation is utilized by businesses of all sizes across industries.Any entity that performs any sort of economic activity utilizes the accounting equation to ensure accuracy and transparency. While it is often associated with an accrual and double-entry accounting system, the accounting equation can be used for other accounting systems as well. 

7) What is the accounting formula?

The accounting equation is often expressed as an accounting formula and states that the sum of liabilities and equity is always equivalent to the total assets of the organization. It is the fundamental foundation of accounting that ensures financial statement accuracy. It also serves as the basis for the double-entry system. 

8) What is the owner’s equity equation in accounting? 

The owner’s equity equation in accounting shows the interrelationship between assets, liabilities and equity. It is derived from the accounting equation and is expressed as Owner’s Equity = Assets – Liabilities. Owner’s equity in accounting is equivalent to the difference between assets and liabilities of an organization.