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The accounting equation forms the basis of the double entry bookkeeping, wherein for each transaction, total debits are equals to total credits (McLaney & Atrill, 2007). Every business transaction usually imposes an impact on the financial position of a business entity, which is measured using assets, liabilities and owners equity. The accounting equation, sometimes referred to as the balance sheet equation, denotes the relationship between assets, liabilities and owners equity, and is used in understanding the relationship existing between the financial statements of a business entity (Warren & Reeve, 2011). This paper provides a description of the accounting equation and the relationship between the accounting equation and the components of the balance sheet.
The Basic Accounting Equation
The accounting equation is expressed as follows:
Assets = Owner’s Equity + Liabilities (for the case of sole proprietorship) or
Assets = Stockholder’s Equity + Liabilities (for the case of a corporation)
Assets refer to the resources that the business owns, such as accounts receivable, machinery and equipment, land and buildings, inventory, cash at hand and bank and prepaid insurance. It is evident from the accounting equation that the total amount of assets is obtained by summing liabilities and owner’s equity (McLaney & Atrill, 2007).
Liabilities refer to the obligations of the business, which are the amounts that the company owes. Liabilities are mostly accounts payable including loans payable, creditors, salaries and wages payable, interests and income taxes payable. Liabilities can be perceived in two dimensions, which include claims by creditors against the assets of the business, and as a source along with the capital (Warren & Reeve, 2011).
Owner’s or stockholders equity, sometimes known as capital, refers to amount left after subtracting liabilities from assets. It usually denotes the amount of investment plus the cumulative net profit of the business that has not been withdrawn by the owner or distributed to the stockholders in the case of corporations (Warren & Reeve, 2011). If two components of the accounting equation are known, the third component can be calculated. A quick look at the balance sheet reveals that it is an extension of the accounting equation.
The accounting formula will always balance if there is accurate record keeping, implying that the amount on the left side must always be equal to the amount on the right side. This balance is maintained for the reason that every business transaction has an effect on at least company accounts. For instance, when the business takes a loan from the bank, there will be an increase the business assets and an increase in liabilities by an equal amount. When a company buys inventory in the form of cash, there will a simultaneous increase and decrease of the company assets. Double entry accounting facilitates the balancing of the accounting equation because every business transaction has an effect on two or more accounts (Warren & Reeve, 2011).
The balance sheet, also referred to as the statement of the financial position of a firm, represents the accounting equation. Assets, liabilities and capital at a specific period in time are represented in the balance sheet. Similar to the accounting formula, the balance sheet indicates the total business assets as equal to the sum of liabilities and capital.
When starting a business, the accounting equation is given by Assets = Owner’s Equity + Liabilities, which translates to $0 = $0 + $0. When the owner deposits $ 2,000 in the company’s checking account, the accounting equation, under the double entry accounting system, is expressed as follows $ 2,000 = $2,000 + $0. The business may opt to buy office equipment using cash amounting to $ 500. The accounting equation will then change to $2000 = $1,500 + $500, this is because expenses reduce owner’s capital. This implies that the asset account of office equipment increased by $500 whereas the cash account decreased by $500.