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The life of an accountant involves a complicated scenario where he/she is usually seen struggling with a number of complexities pertaining to accounting principles. In order to make thing easier for you, let us comprehend and simplify the accounting equation here.
An accounting equation refers to a formula that is beneficial for recording the primary relationship between several financial activities in a business. A simplified breakdown of the numbers, the valued gets entered in the balance sheet of a company or business. This equation further defines the perfect correlation between the assets, the liabilities and the equity of the owner in a organization/business.
The accounting equation acts as the primary foundation that implies that each assets of the company needs to be equal to the liabilities. To explain it in better words, the entries that have been made on the debit side of the balance sheet needs to have a corresponding entry on the side of credit. This is why the basic equation of accounting is referred to as being the equation of balance sheet.
By accounting equation, we refer to a basic accounting principle which is better understood as the core element of the balance sheet.
With the help of the equation, you can acquire a strong understanding of double-entry accounting that point out the layout of the balance sheet.
On the other hand, double-entry accounting refers to a system where all transaction affects each and every side of the equation. There needs to be an equal change to the account of a shareholder’s equity and liability with each time there is a change in the asset account.
Basic Equation: Assets= Liabilities + Equity
An insight to understanding the fundamental components of the equation:
Now that the equation have been framed in front of you, it is essential to understand the factors that make the equation up.
Assets can be defined as anything which can be easily converted into cash. Anyone can own an asset, be it an individual or government. It can be referred to an asset when it can generate substantial amount of revenue and bring profit to the table for the owner.
Apart from an individual, a company consists of two kinds of assets, current and non-current
Current assets can be defined as assets that which one can easily convert into cash in a short period of time, even less than a fiscal period. The assets are beneficial for facilitating everyday expenses such as accounts receivable, cash, inventories and so on.
On the other hand, there are non-current assets which are referred to as fixed assets as the company makes use of them for producing goods and services. These assets comprise property, machinery, land, plant and machinery and so on.
Liability can be explained as an obligation that is owned by a business to another entity. It can be cited as the total value that is expected out of a company to pay. It can be either paid in short term or long term. Similar to the previous component, liability too can be classified as a current and noncurrent based on the context. This comprises of borrowings of a company, either from bank or from an individual. It can also be cited to a previous traction which makes way for an unsettled obligation, bonds payable, accounts payable and others.
This is referred to the entire value of money that a company has raised through issuing shares. The equity is often referred to the retained earnings of a company. As shareholders invest certain amount of their money in an organization, hence they also expect to have some dividends in return. This is why it lies on the side of the liabilities in the book.
The retained earnings can be further segregated into two distinct parts, expenses and revenue. This helps in understanding and comprehending the relationship between income statements along with balance sheet. While the revenue is cited as what the business earns by selling products and services to customers, expenses, on the other hand, refers to the costs incurred by a business to manufacture what it wants to offer. When the revenue gets higher that the costs incurred for manufacturing a product, it is definitely a profitable venture.
It is up to the owner to withdraw an equity or salary from the business. However, when the company is incorporated, the salary then can be a dividend paid by the organization. Situations are however not the same with all companies, for a small and sole proprietorship and limited liability company, owners can draw the salaries from the business.
The balance sheet can be explained as the statement of the position and reports of the assets, the equity of the owners, the liabilities, at a particular point of time. Similar to the accounting equation, it reflects the total assets of a company to be equal to the amount of liabilities in addition to owners’ equity.
The income statement reports the revenue of the company along with the expenses and the resulting income. The income statement covers a particular time period; however the balance sheet is concentrated upon one point in time. It is beneficial for explaining the change in the equity of the owner or the stockholder.
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