Company’s balance sheet has three major section: assets, liabilities and owner’s equity. As a general accounting rule, assets must equals liabilities and owner’s equity. It’s known as balance sheet equation or basic accounting equation, which is the foundation of double-entry accounting system.
The basic accounting equation given below is a simple algebraic formula which ensures that the balance sheet remains balanced.
Asset = liabilities + Owners equity
This basic accounting equation states how three major components of a balance sheet are associated with each other.
Double entry system of bookkeeping ensures that each accounting entry made on the debit side should have a corresponding entry on the credit side to keep the equation balanced.
For instance, if a business takes loan from a bank, the borrowed capital will raise assets and the loan amount will also raise liabilities. In this way, accounting equation will tally with the increase in asset and increase in liability.
Similarly, if company buys raw material by paying cash, it will increase inventory (assets) and reduce cash (asset). In this way, left side of the basic accounting equation will always tally with the right side value.
Assets – Left side of basic accounting equation
Assets are shown on the balance sheet as resources owned or controlled by a company. It includes;
- Cash and cash equivalent,
- Accounts receivable,
- Land, and
Liabilities shown on the balance sheet are company’s obligations as on the reporting date. Company need to pay it to keep running it’s business. Common examples of liabilities includes;
- Accounts payable
- Long-term debt
- Short-term debt
- Rent payable
- Salaries and wages payable
- Utilities payable
Owner’s equity or shareholders equity/capital represents the value of the interest in the assets of the company. Shareholders create interest by contributing to the capital of the company and by retaining the profits over the years. This means it includes two things;
- Invested capital
- Retained earnings
You can get owner’s capital by subtracting liabilities from assets. It’s also referred to as net assets and net worth.
Owner’s equity on the balance sheet represents the amount that has to be returned to shareholders if company is liquidated on the date of reporting.
We know that owner’s equity is share capital of investors plus retained earnings. Therefore, the equation can be derived as follows;
Asset = liabilities + common stock or invested capital + retained earnings
We know that, Retained earnings = opening balance of retained earnings + net profits – dividends
Net profit = Revenue – expenses
After replacing retained earnings and net profit with the above two equation, basic accounting equation can be derived as follows;
Assets = liabilities + common stock + opening balance of retained earnings + Revenue – expenses – dividends
You can calculate the value of company equity by rearranging basic accounting equation as stated below:
Equity = Assets – liabilities
From this accounting equation, equity can be defined as the excess value, if any, of the assets of a company over the value of the liabilities.