What
is the accounting equation?
Why
accounting equation?
What
are the three elements of the accounting equation?
What
are the limitations of the accounting equation?
1.
Introduction
The accounting
equation states that the company's total assets are equal to the sum total of liabilities
and shareholder's equity.
Assets mean the
value of resources controlled by the company. Assets are those things that
increase revenue or decrease the costs of the company.
Liabilities mean the
obligations of the company and to settle the obligations outflow of cash or any
resources are required.
Shareholder's equity means
share capital and reserve and surplus. It indicates residual interest in the
entity after deducting external liabilities. In simple terms, it means total
assets after deducting liabilities.
The accounting equation
is based on the double-entry system of bookkeeping. The double-entry system of bookkeeping ensures that entry made on the debit side has a corresponding entry on the
credit side.
2.
Why accounting equation?
The accounting
equation is also called the basic accounting equation or the balance sheet
equation. It ensures that the balance sheet remains balanced.
The financial
position of a company has three components viz. asset, liability, and equity. The
accounting equation shows the relationship between these components.
Remaining other
things constant:
-The company's equity
will increase when its assets increase, and
-The company's equity
will decrease when its assets decrease.
This case is the opposite
in respect of liabilities. Remaining other things constant:
-The company's equity
will decrease when its liabilities increase, and
-The company's equity
will increase when its liabilities decrease.
3.
What are the three elements of the accounting equation?
The accounting equation
shows how the three components viz. assets, liabilities, and equity are related
to each other.
Assets represent the
resources controlled by the company from which the company earns revenue and or
decreases cost. Examples of assets are cash and cash equivalents, account
receivable, inventory, investments, plant and machinery, land, and buildings.
Liabilities are the
obligations of the entity and to settle obligations outflow of cash or any
other resources are employed. Examples of liability are suppliers, accounts
payable, interest payable, long-term loans, debt, and dividend payable.
Equity means the
residual interest in the company after deducting liabilities. It comprises share capital and retained earnings.
Share capital is the
amount of money introduced by the promoter at the time of the start of the company.
Retained earnings are earnings of the company after deducting the portion that
belongs to outside stakeholders.
4.
What are the limitations of the accounting equation?
As we have seen
accounting equation provides a relationship between three components of the
balance sheet. Although it is very important for today's business, it is not
free from flaws.
It only focuses on
the balance sheet. It fails to depict the performance of the company.
It says nothing about
cash flow patterns and changes in equity.
It is not relevant in
case of changes in accounting policies and accounting estimates.
0 Comments