What is the Accounting Equation?

Considered to be the foundation of the double-entry accounting system, the accounting equation is important because, as explained by Investopedia, it is a concise expression of the complex and multi-item display of a balance sheet. In short, it’s the principle that keeps the balance sheet balanced, with each entry on the debit side having a corresponding entry on the credit side. This is why it is sometimes referred to as the “balance sheet equation.”

The importance of the accounting equation lies in the way it captures the relationship between three elements: Assets, liabilities and equity. It helps accountants to assess whether the business transactions carried out by the company are being accurately reflected in its books.

The elemental and unchanging concepts that are essential in modern accounting are that a company’s owner or shareholder equity will increase when assets increase. With increased liabilities, equity is decreased. With reduced liabilities, achieved by paying off debt for example, equity is increased.

As you can see from the accounting equation itself, there are three elements that make up the whole formula — assets, liabilities and equity. Here's a brief explanation of each element and why they are important to your ability to properly perform accounting tasks.

Assets

Assets are any resources owned by a company. For instance, if you ran a lumber company and had 70,000 lbs. of lumber sitting in a warehouse, that would be considered an asset. Assets also include non-physical holdings, such as prepaid insurance and investments. In order for your accounting to be clear and correct, your assets must always equal the amount of liability plus equity, whether held by shareholders or a sole proprietor.

Liabilities

Liabilities are considered to be anything that is a claim against the company's assets, such as payments or debts that the company owes. Ultimately, liabilities have a negative value representation, and are offset using the double accounting principle. For example, if your company secured a loan from a bank for $10,000, assets would increase by $10,000, as would liabilities.

Equity

Equity is any amount of money remaining after liabilities are subtracted from assets. Due to the nature of the accounting formula, other elements can be moved around as needed to solve for unknown variables. For instance, if you did not know the equity of the company but did know the liabilities and assets, you could subtract liabilities from assets in order to determine the equity. In scenarios where the company is publicly traded, you could then determine individual shareholder equity by calculating the total company equity and then pulling the percentage owned by a particular shareholder.

To help you better understand how the accounting equation works, here is a quick example of how the equation can be used.

Let's say that you are aiming to calculate the total assets owned by the company. In this scenario, you would follow the basic accounting equation formula of Assets = Liabilities + Owner Equity. For this example, let's assume that you have $1000 of liabilities and the owner equity is $5000. You could use the formula in the following manner:

Assets = -$1000 + $5000 Assets = $4000

The origins of the double-entry accounting system, one of the most important concepts in accounting, can be traced back to 15th century Italy. Double-entry accounting, or double-entry bookkeeping, means that for every entry into an account, there needs to be a corresponding and opposite entry into another account. The result of the double entry is a debit entry in one or more accounts, and a corresponding credit entry into one or more accounts on the other side of the balance sheet. The concept of double-entry ensures that a company’s accounts remain balanced, and can be used to make an accurate depiction of the company’s current financial position.

Relying heavily on the accounting equation, the double-entry system and the balance sheet that tracks its results are critical in showing investors, shareholders and government agencies a company’s current financial condition and predicting future earnings.

The accounting equation has a few expanded versions that can be used to calculate different variables, but there are also dozens of different accounting formulas that accountants use to identify crucial elements of a company's finances. Here are a few of these equations along with a brief explanation of how they work.

Gross Profit

Gross profit refers to the total amount of profit left after expenses associated with providing goods or services are removed. Gross profit, also known as gross income, includes only variable costs and does not account for the fixed costs of a business that are not directly attached to production. To calculate the gross profit of sold items, you would use the following formula:

Sales - Cost of Goods Sold = Gross Profit

Gross Profit Margin

Gross profit margin takes the gross profit figure you obtained from the gross profit formula and then divides it by total sales in order to identify the percentage of each sale that you retain every time a product is sold. The formula used to calculate this number is:

Gross Profit / Sales = Gross Profit Margin

Net Income

Net income takes the gross profit figure and then subtracts other expenses that are not necessarily associated with the cost of product creation. For instance, the gross profit calculation would not include fixed expenses such as executive salaries or office rent. To calculate the net income of your company, you would use the following formula:

Income - Expenses = Net Income

Break-Even Point

The break-even point is the point at which your gross income exceeds that of all your expenses across the company. The primary goal of all companies is to reach this point and then continue to increase sales in order to increase overall profits. The following formula is used to calculate the break-even point:

Fixed costs / (Sales price per unit - Variable cost per unit) = Break-Even Point

Cost of Goods Sold (COGS)

Cost of goods sold is a figure used to determine the overall cost that the goods required to produce, including materials and labor. This figure is useful for determining sale price as you can use it to set your overall profit margin for a certain good. The formula used to arrive at this figure is:

Beginning Inventory + Purchases of the Inventory - Ending Inventory = Cost of Goods Sold

Current Ratio

Current ratio shows you the present standing of your company in terms of how many assets your company has compared to its liabilities. Typically, you want to have a higher ratio as that indicates you have more assets than you do liabilities. The following formula can help you identify the current ratio of your company:

Current Assets / Current Liabilities = Current Ratio