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The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s,
liabilities Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liability, the area of law in which manufacturers, distributors, suppliers, re ...
, and owner's equity of a person or business. It is the foundation for the
double-entry bookkeeping system Double-entry bookkeeping, also known as, double-entry accounting, is a method of bookkeeping Bookkeeping is the recording of financial transactions, and is part of the process of accounting in business and other organisations. It involves ...
. For each transaction, the total debits equal the total credits. It can be expressed as furthermore: : \text = \text + \text Meigs and Meigs. ''Financial Accounting, Fourth Edition''. McGraw-Hill, 1983. pp.19-20. : A = L + E : \text = \text + \text Meigs and Meigs. ''Financial Accounting, Fourth Edition''. McGraw-Hill, 1983. pp.19-20. : a = oe + l In a corporation,
capital Capital most commonly refers to: * Capital letter Letter case (or just case) is the distinction between the letters that are in larger uppercase or capitals (or more formally ''majuscule'') and smaller lowercase (or more formally ''minusc ...
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 of its balance sheet 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); note that the profits earned by the company, is ultimately owned by its owners. The
formula In , a formula is a concise way of expressing information symbolically, as in a mathematical formula or a . The informal use of the term ''formula'' in science refers to the . The plural of ''formula'' can be either ''formulas'' (from the mos ...

formula
can be rewritten: :Assets - Liabilities = (
Shareholder A shareholder (in the United States often referred to as stockholder) of a corporation is an individual or legal entity (such as another corporation, a body politic, a Trust law, trust or partnership) that is registered by the corporation as the ...
s' or Owners' Equity) Now it shows owners' equity is equal to
property Property is a system of rights that gives people legal control of valuable things, and also refers to the valuable things themselves. Depending on the nature of the property, an owner of property may have the right to consume, alter, share, r ...
(assets) minus
debts Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...
(liabilities). Since in a corporation owners are
shareholders A shareholder (in the United States often referred to as stockholder) of a corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal ...
, owner's equity is called
shareholders' equity In finance, equity is ownership of asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information ab ...
. Every
accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compare with other ob ...
transaction affects at least one element of the equation, but always balances. Simple transactions also include: These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind
debit Debits and credits in double entry bookkeeping are entries made in account ledger A ledger is a book or collection of accounts in which account transactions are recorded. Each account has an opening or carry-forward balance Balance may refe ...

debit
s,
credits Credit refers to any form of deferred payment, the granting of a loan and the creation of debt. Credit may also refer to: Places * Credit, Arkansas, a ghost town Arts, entertainment, and media * Credit (creative arts), acknowledging the ideas o ...
, and journal entries. This equation is part of the transaction analysis model, for which we also write :Owner's equity = Contributed Capital + Retained Earnings :Retained Earnings =
Net Income In business Business is the activity of making one's living or making money by producing or buying and selling products (such as goods and services). Simply put, it is "any activity or enterprise entered into for profit." Having a busin ...
Dividends A dividend is a distribution of profits by a corporation A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity (a legal entity recognized by private and public law 'b ...

Dividends
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 Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the differe ...
component of the equation.Wild.''Financial Accounting, Third Edition''.McGraw-Hill, 2005. p.13, :Assets = Liabilities + Contributed Capital + Revenue - Expenses - Dividends


Applications

The accounting equation is fundamental to the double-entry bookkeeping practice. Its applications in
accountancy Accounting or Accountancy is the measurement Measurement is the quantification of attributes of an object or event, which can be used to compare with other objects or events. The scope and application of measurement are dependent on the ...
and
economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and interact ...

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 A ledger is a book or collection of accounts in which account transactions are recorded. Each account has an opening or carry-forward balance Balance may refer to: Common meanings * Balance (ability) in biomechanics * Balance (accounting) * Bal ...

ledger
, will provide the material that eventually makes up the foundation of a business's
financial statement Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...
s. This includes expense reports,
cash flow A cash flow is a real or virtual movement of money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...
,
interest In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money availa ...

interest
and
loan In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money avai ...
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 Debits and credits in double entry bookkeeping are entries made in account ledger A ledger is a book or collection of accounts in which account transactions are recorded. Each account has an opening or carry-forward balance Balance may refer ...
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 An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''statemen ...
. This statement reflects
profit Profit may refer to: Business and law * Profit (accounting) Profit, in accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic ...
s and
loss Loss may refer to: People with the surname *Joe Loss (1909–1990), founder of The Joe Loss Orchestra Arts, entertainment, and media Music *Loss (Bass Communion album), ''Loss'' (Bass Communion album) (2006) *Loss (Mull Historical Society album ...
es that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine
revenue In accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to comp ...
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 Net worth is the value of all the non-financial and financial asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and no ...
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, meaning that the assets will show on the books as less than their "real" value, or what they would be worth on the secondary market.


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
creditor A creditor or lender is a party 300px, '' Hip, Hip, Hurrah!'' (1888) by Peder Severin Krøyer, a painting portraying an artists' party in 19th century Denmark A party is a gathering of people who have been invited by a host A host is ...

creditor
s or banks that might be considering a loan application or
investment Investment is the dedication of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance Finance is the study of financial institution ...

investment
in the company.


References

{{Reflist Accounting terminology