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.
