Accounting equation also known as balance sheet equation is considered to be the foundation of double entry system of bookkeeping and accounting being used by sole proprietors, partnerships and multinational corporations. As per the accounting equation, the total value of assets of the business equals to the sum of its liabilities and owner’s equity.
The formula for the accounting equation is as follows:
Assets = Liabilities + Owner’s Equity
The said equation helps in assessing whether transactions performed by the entity are being accurately reflected in its books as well as its accounts.
Let’s say for the financial year ended January 31, 2020, ABC Corporation reported the following on its statement of financial position:
- Total Equity = $30 million
- Total liabilities = $20 million
- Total Assets = $50 million
If we compute the right side of the equation (Liabilities + Equity) we arrive at $50 million which is equal to the value of assets reported by the entity on its statement of financial position.
Foundation of the Double-Entry System
The balance sheet equation forms the foundation of the double-entry accounting system and is a concise and accurate representation of a concept that expands into the complex and multi-item display of the statement of financial position.
Limitations of the Accounting Equation
Even though the balance sheet/ statement of financial position always balances out, the equation does not provide investors and other stakeholders with information regarding how well a business entity is performing. Instead, the investors of the entity must interpret the numbers presented on its financials and decide for themselves whether the entity is being operated properly to ensure long term growth and success.