What is the Accounting Equation?
The Accounting Equation states that the total value of a company’s Assets must equal the total value of its Liabilities and Equity.
It’s called the Accounting Equation because it sets the foundation of the double-entry accounting system. The double-entry accounting system is a method of accounting where every change to the Assets section must have either (1) an offsetting change in Assets section or (2) a matching change to Liabilities and Equity. The system is the go-to accounting method of the modern day. And Accounting Equation is the premise on which the double-entry accounting system is built. Hence, it’s called the Accounting Equation.
This is also a cornerstone concept that underpins the Balance Sheet. The Balance Sheet shows the value of what the company owns (Assets), owes (Liabilities) and value left to owners (Equity). The Accounting Equation captures the relationship between Assets, Liabilities and Equity through a simple formula. It states that the Assets section must equal the sum of the Liabilities and Equity sections. The value of what a company owns must equal the value of what it owes and value left to owners. For this reason, the Accounting Equation is also known as the Balance Sheet Equation.
Accounting Equation Formula[Formula Picture]
This is the standard formula. Assets = Liabilities + Equity. When this formula is true, we say that the Balance Sheet “balances”. Based on this formula, we can rearrange the variables to derive its variations:[Formula Picture]
Assets: Asset is anything that the company controls that has value, anything that benefits the company. Common items in the Assets section include: Cash & Cash Equivalents, Accounts Receivables, Prepaid Expenses, and PP&E.
Liabilities: Liability is anything that has value that the company owes to other parties. Common items under the Liabilities section include: Current Portion of Long-Term Debt, Accounts Payables, Accrued Expenses, Deferred Revenue, Long-Term Debt, and Capital Leases.
Equity: Equity on the Balance Sheet shows the value entitled to the company owners. It’s the value of Assets leftover to the shareholders after covering all Liabilities. Common Equity items include: Common Stock Par Value, Additional Paid-In Capital, Retained Earnings, and Shareholder’s Equity.
Accounting Equation Example
Here’s a real Balance Sheet from Netflix (NASDAQ: NFLX). You can find the company’s Balance Sheet on PDF page 46 of the company’s annual report.[Picture]
On Netflix’s Balance Sheet, we highlighted total Assets in red and total Liabilities & Equity in green. These two lines must always equal. We can see that the company had $25,974,400,000 in total Assets and $25,974,400,000 in total Liabilities & Equity. The Balance Sheet balances.
How to Use the Accounting Equation
People generally use the Accounting Equation for three purposes. First, we use it as a guide in journal entry. Second, we use it to check that the Balance Sheet balances. And third, we use it to solve missing variables.
Guide in Journal Entry:
Accountants use the Accounting Equation as a guide in their journal entries. It helps them frame how they determine accounts to debit & credit. Every transaction alters the company’s Assets, Liabilities and Equity. It’s the accountants’ responsibilities to keep an accurate journal of these transactions. Every transaction’s impact to Assets must have either offsetting impact to Assets or matching impact to Liabilities and Equity.
For example, a $100 increase in an item under Assets must be met with either a $100 decrease in another Asset item or a $100 increase in Liabilities and Equity. If the accountants keeps accurate records, the Accounting Equation will always “balance”. It should always balance because every business transaction affects at least two of a company’s accounts.[Picture]
Suppose a company spends $100 to purchase a chair with cash. The company’s PP&E value increases by $100 because it now owns an extra chair worth $100. But its Cash & Cash Equivalents value decreases by $100 because it used $100 to buy the chair. The $100 increase in PP&E is offset by the $100 decrease in Cash & Cash Equivalents. So the total value of Assets is left unchanged. The Accounting Equation balances.[Picture]
Alternatively, suppose the company decided to borrow $100 to buy the chair as opposed to using its own cash. Then the PP&E will go up by $100, so Assets increase by $100. But Debt will also go up by $100 because the company had borrowed the money. This matching impact increases Liabilities & Equity by $100. The Accounting Equation balances.
Check Balance Sheet:
Remember, the total value of Assets must always equal the total value of Liabilities and Equity. We use the Accounting Equation to check Balance Sheets. Any Balance Sheet whose total Assets value does not equal the sum of its Liabilities and Equity values is wrong.
Step 1: Find the company’s “Total Assets” line on the Balance Sheet.
Step 2: Find the company’s “Total Liabilities & Equity” line on the Balance Sheet. If the company does not have “Total Liabilities & Equity”, add together “Total Liabilities” and “Total Equity”.
Step 3: Compare the values from Step 1 and Step 2 to make sure they are equal. If they are not, the Balance Sheet is wrong.
Total Assets must equal total Liabilities plus total Equity. There are no exceptions. It’s always the case. So simply checking whether the Balance Sheet balance can tell you whether the statement is wrong.
Solve Missing Variables:
Recall that the Accounting Equation is Assets = Liabilities + Equity. Anytime we have two of the three components, we can solve for the third missing variable. For example, if we know a company’s total Asset is $700 and Liabilities is $300, then Equity must equal $400.
Why Assets Must Equal Liabilities Plus Equity
It’s a rule that Assets must always equal Liabilities plus Equity. But why? Why must Assets always equal the sum of Liabilities plus Equity? To answer this question, we need to rearrange the Accounting Equation to as follows:[Equity = Assets – Liabilities]
This formula is a lot easier to understand. If you take the total value of Assets and subtract the total value of Liabilities, then the remainder is value for Equity holders. Said differently, whatever value of the company’s Assets remains after covering its Liabilities belong to the owners. Whatever value is left after the company pays the money it owes to banks, suppliers, and employees belong to the company owners. This is how things work in this world.
The value of your house after paying down mortgage belongs to you. Likewise, whatever value of your car is left after repaying car loans belong to you. Whatever value of your restaurant is left after paying for all the required expenses belong to you. The money in your bank account after you repay outstanding debt (i.e. student loans, mortgage, credit cards) belongs to you.
Suppose you buy a house for $200,000 with $120,000 in mortgage and $80,000 of your own money. The Asset value of the house is $200,000. That’s the value of the house. But you owe $120,000 to the banks. The value of the house after deducting the liability belongs to you, which is $80,000.
You own something after you buy it. And you have to repay what you owe. As long as this is how things work in life, Assets must always equal Liabilities plus Equity.
Limitations of the Accounting Equation
The main limitation of the Accounting Equation is that it doesn’t tell us anything about the company. The formula is more of a principle than a metric that yields significant insight. It tells us how things should be for all companies. It tells us that Assets must equal Liabilities and Equity. Said differently, it states whatever value of Assets left after covering Liabilities is entitled to Equity holders. It doesn’t tell us anything unique about any specific business. It doesn’t tell us how the business is performing, whether its financial health, or how much the company is worth. Investors and analysts have to analyze the financial statements to derive insights into the business performance.
Another limitation of the Accounting Equation is that it can’t tell you if the company’s records are accurately recorded. It can tell you if the records are wrong. If the transactions don’t balance, they’re wrong. But you can’t tell if they’re accurate. A balanced Accounting Equation by itself is insufficient to certify the accuracy of a company’s records. A company’s accounts and Balance Sheet can balance and still for the entries to be wrong. Instead of recording the purchase of the chair for $100, for example, they could record it at $10. So it can tell you if the records are wrong, but it can’t certify if the records are accurate.