Accounting Equation Overview, Formula, and Examples

The accounting equation is a factor in almost every aspect of your business accounting. Obligations owed to other companies and people are considered liabilities and can be categorized as current and long-term chart of accounts list liabilities. Equity is named Owner’s Equity, Shareholders’ Equity, or Stockholders’ Equity on the balance sheet.

Current assets and liabilities can be converted into cash within one year. We use owner’s equity in a sole proprietorship, a business with only one owner, and they are legally liable for anything on a personal level. While dividends DO reduce retained earnings, dividends are not an expense for the company.

Final Thoughts On Calculating The Equation

Retained Earnings is Beginning Retained Earnings + Revenue – Expenses – Dividends – Stock Repurchases. Because the Alphabet, Inc. calculation shows that the basic accounting equation is in balance, it’s correct. The monthly trial balance is a listing of account names from the chart of accounts with total account balances or amounts.

It can be found on a balance sheet and is one of the most important metrics for analysts to assess the financial health of a company. Due within the year, current liabilities on a balance sheet include accounts payable, wages or payroll payable and taxes payable. Long-term liabilities are usually owed to lending institutions and include notes payable and possibly unearned revenue. In this form, it is easier to highlight the relationship between shareholder’s equity and debt (liabilities). As you can see, shareholder’s equity is the remainder after liabilities have been subtracted from assets. This is because creditors – parties that lend money such as banks – have the first claim to a company’s assets.

As a core concept in modern accounting, this provides the basis for keeping a company’s books balanced across a given accounting cycle. Companies compute the accounting equation from their balance sheet. They prove that the financial statements balance and the double-entry accounting system works. The company’s assets are equal to the sum of its liabilities and equity. Accounting equation describes that the total value of assets of a business entity is always equal to its liabilities plus owner’s equity.

1. Assets represent the valuable resources controlled by a company, while liabilities represent its obligations.
2. If a company’s stock is publicly traded, earnings per share must appear on the face of the income statement.
3. The accounting equation is fundamental to the double-entry bookkeeping practice.
4. These equations, entered in a business’s general ledger, will provide the material that eventually makes up the foundation of a business’s financial statements.
5. In double-entry accounting or bookkeeping, total debits on the left side must equal total credits on the right side.

Example Transaction #5: Purchase of Advertising on Credit

Some common partnerships include doctor’s offices, boutique investment banks, and small legal firms. Think of retained earnings as savings, since it represents the total profits that have been saved and put aside (or “retained”) for future use. The major and often largest value assets of most companies are that company’s machinery, buildings, and property.

There are different categories of business assets including long-term assets, capital assets, investments and tangible assets. They were acquired by borrowing money from lenders, receiving cash from owners and shareholders or offering goods or services. A screenshot of Alphabet Inc Consolidated Balance Sheets from its 10-K annual report filing with the SEC for the year ended December 31, 2021, follows. As our example, we compute the accounting equation from the company’s balance sheet as of December 31, 2021.

Current assets include cash and cash equivalents, accounts receivable, inventory, and prepaid assets. Current liabilities are short-term financial obligations payable in cash within a year. Current liabilities include accounts payable, accrued expenses, managing contacts in xero and the short-term portion of debt. The accounting equation uses total assets, total liabilities, and total equity in the calculation. This formula differs from working capital, based on current assets and current liabilities. In above example, we have observed the impact of twelve different transactions on accounting equation.

This straightforward relationship between assets, liabilities, and equity is considered to be the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the debit side has a corresponding entry (or coverage) on the credit side. Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets. Shareholder Equity is equal to a business’s total assets minus its total liabilities.

Nabil invests $10,000 cash in Apple in exchange for $10,000 of common stock. Shareholders, or owners of stock, benefit from limited liability because they are not personally liable for any debts or obligations the corporate entity may have as a business. Shareholders’ equity comes from corporations dividing their ownership into stock shares. However, each partner generally has unlimited personal liability for any kind of obligation for the business (for example, debts and accidents).

How to use the Accounting Equation

If a company’s stock is publicly traded, earnings per share must appear on the face of the income statement. 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. If a company keeps accurate records using the double-entry system, the accounting equation will always be “in balance,” meaning the left side of the equation will be equal to the right side. The balance is maintained because every business transaction affects at least two of a company’s accounts.

From the Statement of Stockholders’ Equity, Alphabet’s share repurchases can be seen. Their share repurchases impact both the capital and retained earnings balances. Accounting software is a double-entry accounting system automatically generating the trial balance.

Example Transaction #3: Purchase of Supplies on Credit

We calculate the expanded accounting equation using 2021 financial statements for this example. Balance Sheets shown above and the Income Statement and detailed Statement of Stockholder’s Equity in this section. Share repurchases are called treasury stock if the shares are not retired. Treasury stock transactions and cancellations are recorded in retained earnings and paid-in-capital. In this expanded accounting equation, CC, the Contributed Capital or paid-in capital, represents Share Capital.