How accounting equation important for business | the ultimate solution
The accounting equation is the basement of double entry accounting. Accounting equation can be stated as balance sheet equation which is co-relation among assets, liabilities, and owners equity in a business. Every transaction has two equal sides one is debt and other is credit. The equation is displayed assets are invested by shareholders or borrowing money to finance in the business. The equation in the basic accounting is:
Accounting equation formula:
Assets = Liabilities + Owners equity
The assets used in an equation as a resource such as cash, accounts receivable, fixed assets, stock inventory.The liabilities part of the equation is usually shows owed from suppliers, outstanding expenses such as salary accrued, income tax payable and bad debts allowance to the lender.
Owners equity is not only invested money from the owner but also add subsequent additional capital from another source such as issuing primary share, add net profit or less net loss then add additional capital at the end, minus withdrawal and you get the result of shareholder’s equity.
After that you can see the relationship among the equation assets, liabilities and owners’ equity all are an equal amount in the balance sheet. In regards, the accounting equations are so important in basic accounting transactions in all aspects. In the recording process of transactions are based on accounting equations which are reflected balance sheet when the amount of the balance all are equal and the forwarding next year balance will be zero. All software built by the concept of accounting equations and the transitions meets the accounting requirement, reject also incorrect accounts.
Accounting equation examples:
XYZ INC. meets in the following transactions in the business period;
- XYZ sells company common share to an investor for $ 12,000.
The transaction will occur cash (assets) increase and the capital increase (equity) account.
- XYZ buys $5000 of inventory from a supplier. The transaction increase inventory (assets) accounts as well as payable (equity) accounts.
- XYZ sells the inventory for $5000. decreeing the inventory (assets) accounts and also decreasing the cost of goods sold accounts (equity)
- The sale of XYZ inventory amounts $ 5000. In these transactions, increasing accounts receivable (assets) as well as increasing income (equity) accounts.
- XYZ collection cash amount from the customer for the sold of inventory. This transaction increase by the cash $ 5,000 (assets) and decrease the receivables (assets) accounts $ 5,000.
These transactions show in the following table:
Now you can see, every transaction is balanced within the accounting equations. Whether it changes on both side of the equations or you may see the transaction cancel itself out on one side of the equation as per formula. In this process, the accounting equation effects in accounts transactions in two sides which one is debit and another are credit are known as double entry accounting.
Similarly, we can discuss another accounting equation questions and answers with explanations about the transaction which is shown as equation in giving an elaborate discussion about it as follows;
- Buy fixed assets on credit. XYZ firm buys a machine on credit for $ 8,000. This is increasing the fixed assets accounts and the increase in the accounts payable (Liabilities) account. This means the assets and the liability side are equal.
- Buy inventory on credit. XYZ Company buys inventory on credit for $ 4000. This increase the inventory (assets) and increasing the accounts payable (liability) which equal assets and liabilities on both side of the transaction.
- Pay dividends XYZ Company pays $ 10,000 in dividends. This transaction reduces the cash account and reducing the retained earnings (Equity) accounts. This transaction shows assets and equity sides are equal.
- XYZ Inc. paying office rent $ 3,000. These transactions reduce the cash (assets) and reduce the accounts payable (liabilities). So the accounts equal assets and liabilities sides.
- Paying supplier invoices. XYZ Company pays $ 20,000 existing suppliers invoices. This reduces the cash (assets) accounts and reducing the accounts payable (Liabilities). Assets and liabilities both are equal of these transactions.
- XYZ company sale goods on credit for $ 20,000. In these transactions increasing accounts receivable (assets) and increasing revenue (Equity) accounts. This transaction reflects both transactions are equal.
- XYZ company sales stock $ 1,00,000 to investors. These transactions the cash (assets) is increasing and other side increases capital stock (Equity). So the transactions equal both side assets and the Equity.
Accounting equation problem:
There is some awkward situation you may face after your records your transactions as well established accounting methods. In this situation it can be total assets cannot be equal to total liabilities and stockholder’s equity. In this situation it may face three kinds of problem which is given below;
You may be the journalizing entry of the transaction that is not equal debit and credit. It is quite impossible if the company this software? Because software indicate the error of the entries debit and credit but it is quite possible if the company recorded the transaction in manual method.
If you use the software which is calculated nearest dollar or thousand dollars then the function may present unbalanced result that why the balance sheet may show unbalanced.
Unbalanced starting numbers:
When you started the using accounting software in your company, you can enter the beginning of the balance at the first of the entries but the software does not show the beginning balance of the transaction endpoint.
Accounting equation for the nonprofit organization:
The equation is varying for the nonprofit entity. The nonprofit organization does not record any shareholders equity that why the equation differs from the profitable organizations.
The equation of nonprofit organization is as follows;
Assets= Liabilities+ Net Assets
The net assets part of the equation which belongs to equity but in the nonprofit organization, it is independently and permanently in the part of equations.
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