The accounting equation is a fundamental concept in accounting that represents the relationship between a company’s assets, liabilities, and equity. It serves as the foundation for analyzing and recording financial transactions.
The accounting equation is expressed as:
Assets = Liabilities + Stockholders Equity
Assets:
Assets are resources owned by a business that have economic value and are expected to provide future benefits.
• Assets can be both tangible and intangible.
Tangible assets include items like cash, inventory, property, and equipment. Intangible assets encompass items such as patents, trademarks, and goodwill.
• Assets are listed on the left side of the accounting equation and are the building blocks of a company’s financial position.
Liabilities:
Liabilities are obligations or debts that a business owes to external parties.
• They represent claims against a company’s assets. Liabilities can be short-term (current liabilities) or long-term (non-current liabilities).
• Examples of liabilities include loans, accounts payable, accrued expenses, and deferred revenue. Liabilities are listed on the right side of the accounting equation.
Shareholders`/Stockholders` Equity:
Shareholders’ equity is the residual interest in the assets of a business after deducting liabilities.
• It represents the ownership interest of the shareholders in the company.
• Shareholders’ equity is composed of common stock, additional paid-in capital, retained earnings, and other comprehensive income. It is located on the right side of the accounting equation.
- Examples when a company borrows money from a bank, the assets of company will increase and its and its liabilities will increase by the same amount
Steps Involved in Developing Accounting Equation
The following steps should be adopted while developing accounting equation:-
- According to business entity concept, identify and screen only business related transactions
- Ascertain the variables (Assets, Liabilities or owner`s equity) of an equations affected by the transactions
- Find out the effect( in terms of increase or decrease ) of an transactions on the variable of the equation
- Show the effect on the appropriate side of an equation.
