Accounting equation

The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a person or business. It is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as further more.

[1][2]
[1][3]


In a corporation, capital represents the stockholders' equity. Since every business transaction affects at least two of a company's accounts, the accounting equation will always be “in balance,” meaning the left side should always equal the right side. Thus, the accounting formula essentially shows that what the firm owns (its assets) is purchased by either what it owes (its liabilities) or by what its owners invest (its shareholders equity or capital).


For example: A student buys a computer for $900. To pay for the computer, the student uses $400 in cash and borrows $500 for the remainder. Now his assets are worth $900, liabilities are $500, and equity $400.

The formula can be rewritten:

Assets - Liabilities = (Shareholders' or Owners' Equity)[1]

Now it shows owners' interest is equal to property (assets) minus debts (liabilities). Since in a corporation owners are shareholders, owner's interest is called shareholders' equity. Every accounting transaction affects at least one element of the equation, but always balances. Simple transactions also include:[4]

Transaction
Number
Assets Liabilities Equity Explanation
1 + 6,000 + 6,000 Issuing stocks for cash or other assets
2 + 10,000 + 10,000 Buying assets by borrowing money (taking a loan from a bank or simply buying on credit)
3 900 900 Selling assets for cash to pay off liabilities: both assets and liabilities are reduced
4 + 1,000 + 400 + 600 Buying assets by paying cash by shareholder's money (600) and by borrowing money (400)
5 + 700 + 700 Earning revenues
6 200 200 Paying expenses (e.g. rent or professional fees) or dividends
7 + 100 100 Recording expenses, but not paying them at the moment
8 500 500 Paying a debt that you owe
9 0 0 0 Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities

These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.

This equation is part of the transaction analysis model,[5] for which we also write

Owner's equity = Contributed Capital + Retained Earnings
Retained Earnings = Net IncomeDividends

and

Net Income = Income − Expenses

The equation resulting from making these substitutions in the accounting equation may be referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation.[6]

Applications

The accounting equation is fundamental to the double-entry bookkeeping practice. Its applications in accountancy and economics are thus diverse.

Financial statement

A company's quarterly and annual reports are basically derived directly from the accounting equations used in bookkeeping practices. These equations, entered in a business's general ledger, will provide the material that eventually makes up the foundation of a business's financial statements. This includes expense reports, cash flow, interest and loan payments, salaries, and company investments.

Double entry bookkeeping system

The accounting equation plays a significant role as the foundation of the double entry bookkeeping system. The primary aim of the double entry system is to keep track of debits and credits, and ensure that the sum of these always matches up to the company assets, a calculation carried out by the accounting equation. It is based on the idea that each transaction has an equal effect. It is used to transfer totals from books of prime entry into the nominal ledger. Every transaction is recorded twice so that the debit is balanced by a credit.

Income and retained earnings

The income and retained earnings of the accounting equation is also an essential component in computing, understanding, and analyzing a firm's income statement. This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly. Thus, the accounting equation is an essential step in determining company profitability.

Company worth

Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm's assets.

However, due to the fact that accounting is kept on a historical basis, the equity is typically not the net worth of the organization. Often a company may depreciate capital assets in 5-7 years. Then those assets have a zero book value. They are fully depreciated. That is however typically not their "worth"

Investments

Due to its role in determining a firm's net worth, the accounting equation is an important tool for investors looking to measure a company's holdings and debts at any particular time, and frequent calculations can indicate how steady or erratic a business's financial dealings might be. This provides valuable information to creditors or banks that might be considering a loan application or investment in the company.[7]

References

  1. ^ a b c Meigs and Meigs. Financial Accounting, Fourth Edition. McGraw-Hill, 1983. pp.19-20.
  2. ^ Financial Accounting 5th Ed,p 47, HornGren, Harrison, Bamber, Best, Fraser, Willet, Pearson/Prenticehall, 2006
  3. ^ Financial Accounting 5th Ed,p 47, HornGren, Harrison, Bamber, Best, Fraser, Willet, Pearson/Prenticehall, 2006
  4. ^ Accounting equation explanation with examples, accountingcoach.com.
  5. ^ Libby, Libby, and Short. Financial Accounting, Third Edition. McGraw-Hill, 2001. p.120
  6. ^ Wild.Financial Accounting, Third Edition.McGraw-Hill, 2005. p.13, ISBN 978-0078025389
  7. ^ "Accounting Equation". Retrieved 30 April 2013.
Accounting identity

In accounting, finance and economics, an accounting identity is an equality that must be true regardless of the value of its variables, or a statement that by definition (or construction) must be true. Where an accounting identity applies, any deviation from numerical equality signifies an error in formulation, calculation or measurement.The term accounting identity may be used to distinguish between propositions that are theories (which may or may not be true, or relationships that may or may not always hold) and statements that are by definition true. Despite the fact that the statements are by definition true, the underlying figures as measured or estimated may not add up due to measurement error, particularly for certain identities in macroeconomics.

Asset

In financial accounting, an asset is any resource owned by the business. Anything tangible or intangible that can be owned or controlled to produce value and that is held by a company to produce positive economic value is an asset. Simply stated, assets represent value of ownership that can be converted into cash (although cash itself is also considered an asset).

The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.One can classify assets into two major asset classes: tangible assets and intangible assets. Tangible assets contain various subclasses, including current assets and fixed assets. Current assets include inventory, while fixed assets include such items as buildings and equipment.

Intangible assets are nonphysical resources and rights that have a value to the firm because they give the firm some kind of advantage in the marketplace. Examples of intangible assets include goodwill, copyrights, trademarks, patents and computer programs, and financial assets, including such items as accounts receivable, bonds and stocks.

Balance (accounting)

In banking and accounting, the outstanding balance is the amount of money owed, (or due), that remains in a deposit account.

In bookkeeping, “balance” is difference between the sum of debit entries and the sum of credit entries entered into an account during a financial period. When total debits exceed total credits, the account indicates a debit balance. The opposite is true when the total credit exceeds total debits, the account indicates a credit balance. If the debit/credit totals are equal, the balances are considered zeroed out. In an accounting period, "balance" reflects the net value of assets and liabilities. To better understand balance in the accounting equation.

Balancing the books refers to the primary balance sheet equation of:

Assets = liabilities plus owner's equity.The first "balancing" of books, or of the balance sheet financial statement in accounting is to check iterations (trial balance) to be sure the equation above applies, and where assets and liabilities are unequal, to equalize them by debiting or crediting owner's equity (i.e. if assets exceed liabilities, equity is increased, if liabilities, exceed assets, equity is decreased, both in the amount needed to balance the equation).

In addition to the balance sheet, the other primary financial statement (the P&L or Profit and Loss Statement) also is balanced against the balance sheet, generally by use of a "plug" such as imputed interest.

Balance sheet

In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business partnership, a corporation, private limited company or other organization such as Government or not-for-profit entity. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition". Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business' calendar year.

A standard company balance sheet has two sides: assets, on the left and financing, which itself has two parts, liabilities and ownership equity, on the right. The main categories of assets are usually listed first, and typically in order of liquidity. Assets are followed by the liabilities. The difference between the assets and the liabilities is known as equity or the net assets or the net worth or capital of the company and according to the accounting equation, net worth must equal assets minus liabilities.Another way to look at the balance sheet equation is that total assets equals liabilities plus owner's equity. Looking at the equation in this way shows how assets were financed: either by borrowing money (liability) or by using the owner's money (owner's or shareholders' equity). Balance sheets are usually presented with assets in one section and liabilities and net worth in the other section with the two sections "balancing".

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words: businesses have assets and so they cannot, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words, businesses also have liabilities.

Balance sheet recession

A balance sheet recession is a type of economic recession that occurs when high levels of private sector debt cause individuals or companies to collectively focus on saving by paying down debt rather than spending or investing, causing economic growth to slow or decline. The term is attributed to economist Richard Koo and is related to the debt deflation concept described by economist Irving Fisher. Recent examples include Japan's recession that began in 1990 and the U.S. recession of 2007-2009.

Bookkeeping

Bookkeeping is the recording of financial transactions, and is part of the process of accounting in business. Transactions include purchases, sales, receipts, and payments by an individual person or an organization/corporation. There are several standard methods of bookkeeping, including the single-entry and double-entry bookkeeping systems. While these may be viewed as "real" bookkeeping, any process for recording financial transactions is a bookkeeping process.

Bookkeeping is the work of a bookkeeper (or book-keeper), who records the day-to-day financial transactions of a business. They usually write the daybooks (which contain records of sales, purchases, receipts, and payments), and document each financial transaction, whether cash or credit, into the correct daybook—that is, petty cash book, suppliers ledger, customer ledger, etc.—and the general ledger. Thereafter, an accountant can create financial reports from the information recorded by the bookkeeper.

Bookkeeping refers mainly to the record-keeping aspects of financial accounting, and involves preparing source documents for all transactions, operations, and other events of a business.

The bookkeeper brings the books to the trial balance stage: an accountant may prepare the income statement and balance sheet using the trial balance and ledgers prepared by the bookkeeper.

Debits and credits

In double entry bookkeeping, debits and credits (abbreviated Dr and Cr, respectively) are entries made in account ledgers to record changes in value resulting from business transactions. Generally speaking (in T-Account terms), if cash is spent in a business transaction, the cash account is credited (that is, an entry is made on the right side of the T-Account's ledger), and conversely, when cash is obtained in a business transaction, it is described as a debit (that is, an entry is made on the left side of the T-Account's ledger). Debits and Credits can occur in any account. For simplicity it is often best to view Debits as positive numbers and Credits as negative numbers. When all the debits and credits that are transacted in each account are added up the resulting account total could be a net Debit (positive number) or a net Credit (negative number). If the total of the account is in a net Debit position (positive), it is generally classified in the Asset section of the balance sheet, whereas accounts that total to a net Credit (negative) are shown in the liability section of the balance sheet. Accounts that relate to the company's profit (example: Sales, Cost of Sales, Expenses) are totaled to yield company earnings and are classified in the Equity section of the balance sheet. When recording incoming cash (revenue) a Debit will be made to Cash or equivalent Assets and a Credit will be made on the revenue account in the income statement. If a company has a postitive Net Income, the Retained Earnings will receive a Credit when closing out the Income Statement for the year, while a Net Loss will result in a Debit to the Retained Earnings. A net Credit (negative) balance in Retained Earnings in the Equity Section demonstrates that the company has been profitable over time, whereas a Debit (positive) balance in the Equity section, would demonstrate that the company has been unprofitable. In most companies the following accounts end-up in Credit positions: accounts payable, share capital, loans payable; while Debit accounts typically include Equipment, Inventory, Accounts Receivable. Debits (positive numbers) must equal Credits (negatives) in each transaction; individual transactions may require multiple debit and credit entries.For the company as a whole, the net position of every account (debit or credit) is shown in the trial balance report. The trial balance report must add to zero; otherwise an error has occurred.Accountants group accounts from the trial balance report to prepare financial statements.

Demography

Demography (from prefix demo- from Ancient Greek δῆμος dēmos meaning "the people", and -graphy from γράφω graphō, implies "writing, description or measurement") is the statistical study of populations, especially human beings. As a very general science, it can analyze any kind of dynamic living population, i.e., one that changes over time or space (see population dynamics). Demography encompasses the study of the size, structure, and distribution of these populations, and spatial or temporal changes in them in response to birth, migration, aging, and death. Based on the demographic research of the earth, earth's population up to the year 2050 and 2100 can be estimated by demographers. Demographics are quantifiable characteristics of a given population.

Demographic analysis can cover whole societies or groups defined by criteria such as education, nationality, religion, and ethnicity. Educational institutions usually treat demography as a field of sociology, though there are a number of independent demography departments.Formal demography limits its object of study to the measurement of population processes, while the broader field of social demography or population studies also analyses the relationships between economic, social, cultural, and biological processes influencing a population.

Double-entry bookkeeping system

Double-entry bookkeeping, in accounting, is a system of bookkeeping so named because every entry to an account requires a corresponding and opposite entry to a different account. The double entry has two equal and corresponding sides known as debit and credit. The left-hand side is debit and right-hand side is credit. For instance, recording a sale of $100 might require two entries: a debit of $100 to an account named "Cash" and a credit of $100 to an account named "Revenue."[further explanation needed]

The accounting equation

is an error detection tool; if at any point the sum of debits for all accounts does not equal the corresponding sum of credits for all accounts, an error has occurred. However, satisfying the equation does not guarantee that there are no errors; the ledger may still "balance" even if the wrong ledger accounts have been debited or credited.

Equity (finance)

In accounting, equity (or owner's equity) is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:

For example, if someone owns a car worth $15,000 (an asset), but owes $5,000 on a loan against that car (a liability), the car represents $10,000 of equity. Equity can be negative if liabilities exceed assets. Shareholders' equity (or stockholders' equity, shareholders' funds, shareholders' capital or similar terms) represents the equity of a company as divided among shareholders of common or preferred stock. Negative shareholders' equity is often referred to as a shareholders' deficit.

Alternatively, equity can also refer to a corporation's share capital (capital stock in American English). The value of the share capital depends on the corporation's future economic prospects. For a company in liquidation proceedings, the equity is that which remains after all liabilities have been paid.

Expense

Expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often referred to as an expense. An expense is a cost that is "paid" or "remitted", usually in exchange for something of value. Something that seems to cost a great deal is "expensive". Something that seems to cost little is "inexpensive". "Expenses of the table" are expenses of dining, refreshments, a feast, etc.

In accounting, expense has a very specific meaning. It is an outflow of cash or other valuable assets from a person or company to another person or company. This outflow of cash is generally one side of a trade for products or services that have equal or better current or future value to the buyer than to the seller. Technically, an expense is an event in which an asset is used up or a liability is incurred. In terms of the accounting equation, expenses reduce owners' equity. The International Accounting Standards Board defines expenses as:...decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Expense account

An expense account is the right to reimbursement of money spent by employees for work-related purposes. Some common expense accounts are: administrative expense, amortization expense, bad debt expense, cost of goods sold, depreciation expense, freight-out, income tax expense, insurance expense, interest expense, loss on disposal of plant assets, maintenance and repairs expense, rent expense, salaries and wages expense, selling expense, supplies expense and utilities expense.

Financial accounting

Financial accounting (or financial accountancy) is the field of accounting concerned with the summary, analysis and reporting of financial transactions pertaining to a business. This involves the preparation of financial statements available for public consumption. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision making purposes.

Financial accountancy is governed by both local and international accounting standards. Generally Accepted Accounting Principles (GAAP) is the standard framework of guidelines for financial accounting used in any given jurisdiction. It includes the standards, conventions and rules that accountants follow in recording and summarizing and in the preparation of financial statements.

On the other hand, International Financial Reporting Standards (IFRS) is a set of passionable accounting standards stating how particular types of transactions and other events should be reported in financial statements. IFRS are issued by the International Accounting Standards Board (IASB). With IFRS becoming more widespread on the international scene, consistency in financial reporting has become more prevalent between global organizations.

While financial accounting is used to prepare accounting information for people outside the organization or not involved in the day-to-day running of the company, managerial accounting provides accounting information to help managers make decisions to manage the business.

Freight expense

In accounting, the concept of a freight expense or freight spend account can be generalized as a payment for sending out a product to a customer. It falls under the umbrella category of expenses and is treated like other expense accounts in relation to the accounting equation, however, under generally accepted accounting rules, if the freight is considered part of the cost of an asset it is recorded as part of the value of the asset on the balance sheet as laid down cost. Freight expense has a normal debit balance. Increases are recorded as debits while decreases are recorded as credits. In relation to other accounts, the Freight Expense account is similar to the "Cost of Sales-Freight" account, but are two totally different entities. While the Freight Expense account is increased for payments towards outgoing goods, the Cost of Sales-Freight account is increased for payments towards incoming goods.

For example, suppose you have a business that imports and exports a type of product. When you deliver goods to customers and you pay for the delivery costs, you increase the Freight Expense account with a debit and the Cost of Sales-Freight is unaffected. However, when you purchase goods from a supplier and you pay for the delivery costs, you increase the Cost of Sales-Freight account and the Freight Expense account is unaffected.

General journal

General journal is a daybook or journal which is used to record transactions relating to adjustment entries, opening stock, accounting errors etc. The source documents of this prime entry book are journal voucher, copy of management reports and invoices.

The journal is where double entry bookkeeping entries are recorded by debiting one or more accounts and crediting another one or more accounts with the same total amount. The total amount debited and the total amount credited should always be equal, thereby ensuring the accounting equation is maintained.

In accounting and bookkeeping, a journal is a record of financial transactions in order by date.

A journal is also named the book of original entry, from when transactions were written in a journal prior to manually posting them to the accounts in the general ledger or subsidiary ledger. Manual systems usually had a variety of journals such as a sales journal, purchases journal, cash receipts journal, cash disbursements journal, and a general journal.

Depending on the business's accounting information system, specialized journals may be used in conjunction with the general journal for record-keeping. In such case, use of the general journal may be limited to non-routine and adjusting entries.

A general journal entry includes the date of the transaction, the titles of the accounts debited and credited, the amount of each debit and credit, and an explanation of the transaction also known as a Narration.

General ledger

A general ledger contains all the accounts for recording transactions relating to a company's assets, liabilities, owners' equity, revenue, and expenses. In modern accounting software or ERP, the general ledger works as a central repository for accounting data transferred from all subledgers or modules like accounts payable, accounts receivable, cash management, fixed assets, purchasing and projects. The general ledger is the backbone of any accounting system which holds financial and non-financial data for an organization. The collection of all accounts is known as the general ledger. Each account is known as a ledger account. In a manual or non-computerized system this may be a large book.

The statement of financial position and the statement of income and comprehensive income are both derived from the general ledger. Each account in the general ledger consists of one or more pages. The general ledger is where posting to the accounts occurs. Posting is the process of recording amounts as credits (right side), and amounts as debits (left side), in the pages of the general ledger. Additional columns to the right hold a running activity total (similar to a chequebook).

The listing of the account names is called the chart of accounts. The extraction of account balances is called a trial balance. The purpose of the trial balance is, at a preliminary stage of the financial statement preparation process, to ensure the equality of the total debits and credits.

The general ledger should include the date, description and balance or total amount for each account. It is usually divided into at least seven main categories. These categories generally include assets, liabilities, owner's equity, revenue, expenses, gains and losses. The main categories of the general ledger may be further subdivided into subledgers to include additional details of such accounts as cash, accounts receivable, accounts payable, etc.

Because each bookkeeping entry debits one account and credits another account in an equal amount, the double-entry bookkeeping system helps ensure that the general ledger is always in balance, thus maintaining the accounting equation:

.

The accounting equation is the mathematical structure of the balance sheet. Although a general ledger appears to be fairly simple, in large or complex organizations or organizations with various subsidiaries, the general ledger can grow to be quite large and take several hours or days to audit or balance.[citation needed]

Liability (financial accounting)

In financial accounting, a liability is defined as the future sacrifices of economic benefits that the entity is obliged to make to other entities as a result of past transactions or other past events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.

A liability is defined by the following characteristics:

Liabilities in financial accounting need not be legally enforceable; but can be based on equitable obligations or constructive obligations. An equitable obligation is a duty based on ethical or moral considerations. A constructive obligation is an obligation that is implied by a set of circumstances in a particular situation, as opposed to a contractually based obligation.

The accounting equation relates assets, liabilities, and owner's equity:

The accounting equation is the mathematical structure of the balance sheet.

Probably the most accepted accounting definition of liability is the one used by the International Accounting Standards Board (IASB). The following is a quotation from IFRS Framework:

Regulations as to the recognition of liabilities are different all over the world, but are roughly similar to those of the IASB.

Examples of types of liabilities include: money owing on a loan, money owing on a mortgage, or an IOU.

Liabilities are debts and obligations of the business they represent as creditor's claim on business assets.

Normal balance

Normal balance is the accounting classification of an account. It is part of double-entry book-keeping technique.

An account has either credit (Abbrev. CR) or debit (Abbrev. DR) normal balance. To increase the value of an account with normal balance of credit, one would credit the account. To increase the value of an account with normal balance of debit, one would likewise debit the account.

The fundamental accounting equation is the following:

Asset = Liability + Owner's equity

The account on left side of this equation has a normal balance of debit.

The accounts on right side of this equation have a normal balance of credit. The normal balance of all other accounts are derived from their relationship with these three accounts.

Normal balance of common accounts:

Asset: Debit

Liability: Credit

Owner's Equity: Credit

Revenue: Credit

Expense: Debit

Retained Earnings: Credit

Dividend: Debit

PyBookie

pyBookie is an open source Python script used for home accounting. It is a basic accounting program, lacking most features which most other accounting software include; however, it is enough to use as a double-entry accounting system.

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