The accounting equation is a basic principle of accounting and a fundamental element of the balance sheet. The equation is as follows:
|Total Assets = Current Assets + Non-Current Assets|
|Total Liabilities = Current Liabilities + Non-Current Liabilities|
|Total Shareholders’ Equity = Share Capital + Retained Earning|
Assets = Liabilities + Shareholder’s Equity
This equation sets the foundation of double-entry accounting and highlights the structure of the balance sheet. Double-entry accounting is a system where every transaction affects both sides of the accounting equation. For every change to an asset account, there must be an equal change to a related liability or shareholder’s equity account. It is important to keep the accounting equation in mind when performing journal entries.
The balance sheet is broken down into three major sections and its various underlying items: Assets, Liabilities, and Shareholder’s Equity.
Below are some examples of items that fall under each section:
- Assets: Cash, Accounts Receivable, Inventory, Equipment
- Liabilities: Accounts Payable, Short-term borrowings, Long-term Debt
- Shareholder’s Equity: Share Capital, Retained Earnings
The accounting equation shows the relationship between these items.
Rearranging the Accounting Equation
The accounting equation can also be rearranged into the following form:
Shareholder’s Equity = Assets – Liabilities
In this form, it is easier to highlight the relationship between shareholder’s equity and debt (liabilities). As you can see, shareholder’s equity is the remainder after liabilities has been subtracted from assets. This is because creditors – parties that lend money – have the first claim to a company’s assets.
For example, if a company becomes bankrupt, its assets are sold and these funds are used to settle debts first. Only after debts are settled are shareholders entitled to any of the company’s assets to attempt to recover their investments.