Definition
The accounting equation or, in other words, the balance sheet equation, can be defined as the relation between the assets, capital and liabilities. It is fundamental for the double-entry bookkeeping practice. The formula for counting the assets is:
Equity + Liabilities = Assets
- Equity represents the ownership in any asset after the debts connected to that asset are paid off.
- Liability represents legal debts that occur in business during the course of business operations.
- Asset is any property owned by an individual or a company, which has some value and is able to meet debts, commitments and legacies.
Application
The accounting equation can be applied in diverse financial situations.
- Financial statements – all of the financial reports derive from the balance sheet and quarterly and annual reports of a company’s financial activities are derived straightly from the accounting equations which are used in bookkeeping.
- Double-entry bookkeeping system – the most important role that the accounting equation has is that it is the foundation of the double-entry bookkeeping system. Double-entry system means that all transactions are documented without an exception.
- Income and retained earnings – company’s income statement can be computed from the balance sheet.
- Company worth – the accounting equation can be used to determine the net worth of a company.
- Investments – it is one of the most important tools for investors who want to measure company’s holdings and debts at any moment in order to see how steady or erratic a business is financially.
Other accounting formulas
There are many other important accounting formulas besides the accounting equation.
- Net income formula (Revenues – Expenses = Net income) – it sums total of accountants’ work.
- Cost of goods sold (Cost of beginning inventory + Cost of purchases – Cost of ending inventory = Cost of goods sold) – it measures how much the company needs to pay for inventory items.
- Contribution margin (Total sales – Total variable cost = Total contribution margin) – it measures how net income increases by selling one or more items.
- Price variance ((Standard price – Actual price) x Actual quantity = Price variance) – it is used to show how an unexpected change in the cost of materials can affect total cost.
- Quantity variance (Standard price x (Standard quantity – Actual quantity) = Quantity variance) – it measures how using too much or not enough materials affects total cost.
