If your small business uses the double-entry accounting system for bookkeeping, a method that involves recording each financial transaction twice (as a debit in one accounting register and a credit in another), you may have heard the term basic accounting equation.
But what is this accounting equation? And why is it important to your business’s financial success? Here’s a closer look.
The Accounting Equation is a Balancing Act
Double-entry accounting requires a clear understanding of the accounting equation because it is the foundation of your company’s balance sheet, which expresses your business’s assets, liabilities, and owner’s/shareholder’s equity in detail.
While very small or simple businesses can sometimes make single-entry accounting work, everyone else is wise to use the double-entry accounting—in part because it has error-avoidance built right in.
The accounting equation formula is: Assets = Liabilities + Owners’ or Stockholders’ Equity.
This equation contains three of the five so called “accounting elements”—assets, liabilities, equity. The remaining two elements, revenue and expenses, are still important (and you still need to track them) because they indicate how much money you are bringing in and how much you are spending. However, revenue and expenses are not part of the accounting equation.
What Are Assets, Liability and Equity?
For the purpose of calculating the results of the accounting equation, it is important to correctly define assets, liabilities and equity. The definitions are:
Assets: An asset is anything your business owns outright. This includes tangible assets (e.g. receivables, inventory, equipment, vehicles and real estate), intangible assets (intellectual property, like a patent, a copyright, or a trademark — is an example of an intangible asset) and cash.
Liabilities: A liability is a financial obligation your business is required to meet. Some liabilities involve debt, while others are simply a part of your essential business operations. Examples of liabilities include wages, taxes, and credit card and/or lease payments. Liabilities due within 12 months are considered short term, or current, liabilities. Long-term liabilities have due dates that are at least 12 months out.
Owners’ Equity or Stockholders’ Equity: Not to be confused with the value of the business, this piece of the accounting equation refers to the percentage of the business that belongs to you or, in the case of a corporation, to stockholders. In terms of the accounting equation, owner’s equity is sometimes expressed as assets minus liabilities. In other words, assets – liabilities = owners’ equity.
In terms of results, in double-entry accounting both sides of the accounting equation are required to balance out at all times. For example, if your business assets total $200,000, the sum of your liabilities plus the owners’ or stockholders’ equity also equals $200,000. If it doesn’t balance, go back and check for an accounting or data entry error.
Here are four practical examples of how the accounting equation works in a double-entry system.
If you borrow $25,000 from a bank, your assets increase by $25,000. However, because you have to pay the loan back, your liabilities also increase by $25,000.
If you finance invoices worth $1,300, your assets increase by $1,300. So do your liabilities.
If you make a $5,000 sale, your assets increase by $5,000. Likewise, the owner’s equity increases by $5,000 as well.
If you purchase $8,000 worth of equipment, your liabilities increase by $8,000 while owner’s equity decreases by $8,000.
What Is the Accounting Equation Used for?
One of the main benefits of using the accounting equation is the fact that it provides an easy way to verify the accuracy of your bookkeeping. It also helps measure the profitability of your business. Are your liabilities significantly higher than your assets? This may indicate that you aren’t managing your money very well. On the other hand, if the equation balances, it is a good indication that your finances are on the right track.
All of this information is useful to you as a business owner, of course. However, it is also useful to potential investors and lenders because, in the event that you decide to seek financing, a balanced accounting equation helps demonstrate whether an investment in your business is a financially sound one (rather than one they are compelled to reject).