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.

  1. 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.
  2. 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.
  3. Income and retained earnings – company’s income statement can be computed from the balance sheet.
  4. Company worth – the accounting equation can be used to determine the net worth of a company.
  5. 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.

  1. Net income formula (Revenues – Expenses = Net income) – it sums total of accountants’ work.
  2. 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.
  3. Contribution margin (Total sales – Total variable cost = Total contribution margin) – it measures how net income increases by selling one or more items.
  4. 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.
  5. Quantity variance (Standard price x (Standard quantity – Actual quantity) = Quantity variance) – it measures how using too much or not enough materials affects total cost.