The accounting equation is the basis of a complex accounting system that you operate. Just like an ocean is made up of a million drops and a word is made of several characters, the foundation of all accounting problems lies in the accounting systems. But do you know everything about the accounting equation? Accounting assignment help expert is there for your rescue.
I have been in this game for too long and what better way is there to tell you that I care for you other than giving you a free session about accounting equation?
Professor, how would you actually define an accounting problem?
Beginning with the roots? I like that, Megan.
The accounting equation is the foundation of a double entry accounting system. We will have a class on what is double entry accounting system some other fine day. Anyway, we use an accounting equation to see the balance sheet of the company. Using that, we can check if the total of the company’s assets is equal to the sum of liabilities and equity to the shareholders.
Since there are two entries in the ledger, the accounting system is called double entry accounting system. The use of accounting equation is to keep the balance sheet “balanced” and ascertain that every entry in the debit section has a corresponding entry in the credit section.
Professor, what is the mathematical representation of the accounting equation?
Excellent question, Mark. Since it is an equation, leave no doubt that there is a mathematical representation to this.
So, the mathematical representation of the accounting equation is –
Professor, how do we calculate the accounting equation?
Using the accounting equation to find the solution to accounting equation problems is really easy. There are a few simple steps to use the accounting equation in a balance sheet –
- Identify the time period for which you have to analyse the balance sheet and locate the assets of the company.
- Liabilities will be mentioned as a separate section in the balance sheet. Sum them all.
- Pull out all the shareholder’s equity and total them. Add the number obtained to the total liabilities.
- The total assets will be equal to the sum of the shareholder’s equity and total liabilities.
Professor, is there any useful significance of the accounting equation?
No matter how small or big the business is, they are analysed primarily on the basis of two factors – assets and liabilities. And this financial position is judged through the data obtained from the balance sheet. The equity of the shareholders is the third section of the balance sheet and is an important one.
To see how these three components of the balance sheet are related to each other, one must be aware of what an accounting equation is. That is the reason why we call the accounting equation the basic accounting equation or the balance sheet equation.
The assets are everything (the valuable resources majorly) that the company owns and the liabilities are the obligations of the company. Shareholder’s equity and the liabilities are a measure of how much the assets of a company are financed. If the company has taken a loan and is in debt, then this is a liability. If the company was financed by issuing equity shares to the investors, then this is the shareholder’s equity.
We check the business transactions of the company for an assessment of their accuracy through accounting equations.
Professor, what are the listed items on a balance sheet?
The assets are made up of liquid assets which are also known as cash and cash equivalents. They also include treasury bills and certificates of deposits. The account receivables are also a form of money.
This is the amount that the customers owe to the company for the sale of the products and services.
If the company maintains an inventory, it is also an asset.
Any expense that the company has to incur to keep the show running is called a liability. Also, if the company owes anyone, it is also counted under the umbrella of liability.
The liabilities of an organisation include –
- Long term debts
- Expense on the utilities
- Taxes paid
- Salaries paid to the employees
- Wages paid to the contractual workers
- Dividends paid to the shareholders
When you subtract the company’s total liabilities from the total assets, you will get the shareholder’s equity for the company.
What does this amount signify? This amount shows the total money that will be paid to the shareholders if the company sells all the assets (or all the assets are liquidated) and all the debts are paid off.
Shareholder’s equity has another part which is called retained earnings. This is equal to the percentage of net earnings that were not paid to the shareholders as dividends. The companies have a habit of not distributing the entire profits among the shareholders. It is kind of a saving that is retained to be used in the future.
Professor, can you explain accounting equation problems through an example?
Let me explain it through a hypothetical example, okay?
So, for a fiscal year, ABC Limited reported the following on the balance sheet –
- Total assets = $100 million
- Total liabilities = $40 million
- Shareholder’s equity = $60 million
Sum of liabilities and equity = $40 million + $60 million = $100 million
This is equal to the total assets as reported by the company.
Pretty simple, isn’t it?
Professor, is there any limitation of the accounting equation?
I really like the way you are thinking, John. You are getting the hang of this. Yes, there are limitations to the accounting equation. No process in the world is 100% accurate and correct. Just like that, the accounting equation problems are also subject to limitations when seen from the perspective of an investor looking for a potential investment opportunity in an organisation.
The investor does not get any value out of the accounting equation. Even though the balance sheet balances out, simply this observation is not sufficient to see how well the company is performing. The way of checking this is to see the number of liabilities that the company has. This means that the investor has to read the balance sheet. Through this, the investor can judge if the company is performing well on the basis of the number of liabilities there are. Or maybe the company has too many assets and looks promising or if the company has enough finances to ensure a long term growth.
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