This essay discusses the key concept in accounting – the accounting equation. In order to understand the meaning of this conception and show how it works in real life we will explain the relation among the components of the balance sheet and the accounting equation, and also discuss the transformations of accounting equation due to transactions.
According to Kimmel, P. D. and Weygandt, J. J. (2011) the basic accounting equation is an expression that shows the relationship among the categories on the balance sheet in equation form:
Assets = Liabilities + Stockholders’ Equity
So, as we see from the above formula, the basic accounting equation is the main rule for creating the balance sheet. The left side of the balance sheet (which is called assets), according to the equation, equals the right side (liabilities or debt plus stockholders’ equity). This equation may be illustrated with the simple, but very demonstrative example. A student buys a book for $120. To make a purchase he borrowed $100 from his roommate and had another $20 earned from the selling of his used book. Now the student’s assets are worth $120, liabilities are $100, and equity (or capital in other words) is $20.
Accounting transaction implies the change in assets, liabilities or stockholders’ equity items due to some economic event that requires recording. For instance, the firm sells its car for 1000$ in order to make annual loan payment. In this case, on the balance sheet both assets and liabilities are reduced by 1000$ as in accounting terminology the firm sells assets for cash to pay off its debt. If the firm earned 2000$ on operating activities, we may have 2000$ increase in both assets and stockholders’ equity. So, as we may see at the provided examples, every accounting transaction changes at least one element of the equation, but it always balances.
Here we looked at the simplest version of the accounting equation. After breaking down the stockholders’ equity into smaller parts, we would receive the expanded version of the accounting equation:
Assets = Liabilities + Common Stock + Income – Expenses – Dividends.
In practice, even the most complicated transactions can be recorded in the similar way by making few substitutions.
In conclusion, I would say that the accounting equation is the main rule for building the financial statements. A developed form of this formula creates a basis for the balance sheet itemizing all assets, liabilities, and equity, as well as totals to verify that the balance is hold.