The Accounting Equation, Explained

accounting formula

Here are our top six formulas to help you stay on top of your small-business accounting. When you combine the formula for net income with total cost, you arrive at another formula that shows you how volume affects profits. Market value ratios are also important when you’re ready to sell your business and must determine its valuation.

Each entry on the debit side must have a corresponding entry on the credit side (and vice versa), which ensures the accounting equation remains true. In all financial statements, the balance sheet should always remain in balance. T Accounts are informal financial records used by a company as part of the double-entry bookkeeping process. For every transaction, at least two classes of accounts are impacted.

Understanding the Accounting Equation

Think of retained earnings as savings, since it represents the total profits that have been saved and put aside (or “retained”) for future use. This number is the sum of total earnings that were not paid to shareholders as dividends. She has been working in the writing sphere for the last five years, covering everything from breaking news to lifestyle features, and now digital payments. Caroline previously served as the Marketing Coordinator at PaymentCloud, a merchant services provider that offers hard-to-place solutions for business owners across the nation.

The accounting equation is a fundamental principle of accounting that states that the total value of an entity’s assets must equal the total value of its liabilities plus its equity. This equation is used to ensure that companies’ financial statements are accurate. The accounting equation is fundamental to the double-entry accounting system and, put simply, it states that the assets of a business must equal its liabilities & owner’s equity.

What is the Basic Accounting Equation?

Other types of liabilities include rent and taxes, which businesses must pay in order to operate successfully. If essential payments like these or utilities go unpaid for too long, they can become liabilities as well. An automated accounting system is designed to use double-entry accounting. When you review each entry and the trial balance, you can make sure that total debits equal total credits, and that the accounting equation holds true.

accounting formula

For a complete list, refer to our full lists of accounting terms and accounting principles. In other words, the total amount of all assets will always equal the sum of liabilities and shareholders’ equity. It can be defined as the total number of dollars that a company would have left if it liquidated all of its assets and paid off all of its liabilities.

Cost of Goods Sold (COGS)

Assets represent the valuable resources controlled by the company, while liabilities represent its obligations. Both liabilities and shareholders’ equity represent how the assets of a company are financed. If it’s financed through debt, it’ll show as a liability, but if it’s financed through issuing equity shares to investors, it’ll show in shareholders’ equity. Under the double-entry accounting system, each recorded financial transaction results in adjustments to a minimum of two different accounts. A company’s “uses” of capital (i.e. the purchase of its assets) should be equivalent to its “sources” of capital (i.e. debt, equity).

  • However, maintaining this equality does not ensure that the financial statements are correct; errors can exist even if the accounting equation balances.
  • An automated accounting system is designed to use double-entry accounting.
  • If something is off, research your financial documents to make sure all transactions are accurate in your records.
  • This is the “assets” portion of the balance sheet, or the entire top portion of it.
  • Use the balance sheet equation when setting your budget or when making financial decisions.
  • The accounting equation is considered the foundation of double-entry bookkeeping, where every transaction gets recorded as a debit in one account and a credit in another.

You only enter the transactions once rather than show the impact of the transactions on two or more accounts. This makes our list of important accounting formulas because once you understand it, you can see at a glance how healthy your business is. For example, let’s say the balance of your bank accounts, plus your other assets (like computers, furniture, etc.) and your accounts receivable total $15,000.

The equation helps support the double-entry accounting system which indicates that every entry has an opposing credit entry. Most small business owners don’t feel entirely confident when it comes to things like accounting and managing business finances. After all, you started your business to follow your heart, not to solve equations. And while these equations seem pretty straightforward on paper, they can get a bit more complicated in practice. The net income equation, then, shows you how profitable your business’ operations are, but not how healthy your cash flow is. Fortunately, in the real world, you’ll only need to use a fraction of the accounting math you learned in school.

It is also known as an Accounting Equation balance sheet since it tells us the relation between balance sheet items, i.e., Assets, Liabilities, and Equity. With the accounting equation, you can better manage your business’s finances and evaluate your business transactions to determine whether they’re accurately reported. If both ledgers of your balance sheet don’t match, there may be an error. Although the balance sheet always balances out, the accounting equation can’t tell investors how well a company is performing.

To understand this equation better we need to understand the different components of this accounting equation. In this article, we’ll look at assets, liabilities and owner’s (or shareholders’) The Importance of Accurate Bookkeeping for Law Firms: A Comprehensive Guide equity to help you learn the fundamental accounting equation. The expanded accounting equation shows the relationship between your balance sheet and income statement.

accounting formula