The accounting equation is the foundation of the double-entry accounting system and has three elements: assets, liabilities, and equity.
Businesses use the accounting equation to ensure that their balance sheets are balanced. An entry on the side of the sheet must have a reciprocal entry on the credit side.
What are assets, liabilities, and equity, and how do they fit into the accounting equation? In this article, we’re going to break down the components of the accounting equation and explain how it helps business owners better understand their business’s actual health.
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What is The Accounting Equation?
The Accounting Equation says that a company’s assets are equal to its liabilities plus a company’s equity.
Accounting Equation: Assets = Liability + Equity
The accounting equation demonstrates how the three components of a balance sheet, assets, liabilities, and equity, work together on the balance sheet.
Businesses use the accounting equation to analyze whether their business transactions are reflected accurately in their accounts and books.
What Are Assets?
The International Financial Reporting Standards (IFRS) define an asset as “a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.”
An asset is something that a company owns that can bring positive economic benefits to a company.
Examples of Assets
Everyday examples of assets:
- Investments
- Inventory
- Furniture
- Cash
- Accounts Receivable
- Patents
Properties of Assets
Assets have three basic properties:
- Resource: An asset can generate economic benefits in the future.
- Ownership: An asset is owned by a company and can be converted into cash.
- Economic Value: An asset has monetary value and can be sold or exchanged.
Classifications of Assets
Assets can be classified by their convertibility, physical existence, and usage.
Convertibility
When assets are classified on how easily they can be converted into cash by a company, they are either fixed or current assets.
Fixed Assets
Fixed or non-current assets cannot be quickly converted into cash. Therefore, fixed assets are also called long-term, hard, or non-current assets.
Examples of Fixed Assets:
- Trademarks
- Land
- Patents
- Buildings
- Equipment/Machinery
Current Assets
Current or liquid assets can quickly be converted into cash, usually within one year.
Examples of Current Assets:
- Office Supplies
- Cash
- Inventory
- Short-Term Deposits
- Accounts Receivable
Physical Existence
When assets are classified based on whether they exist physically or not, they are tangible or intangible.
Tangible Assets
Tangible assets exist physically in the world.
Examples of Tangible Assets:
- Land
- Securities
- Buildings
- Inventory
- Cash
Intangible Assets
Intangible assets are intellectual and do not exist physically.
Examples of Intangible Assets:
- Intellectual Property
- Patents
- Copyrights
- Trademarks
- Brand
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Usage
Assets classified based on purpose or usage are operating or non-operating assets.
Operating Assets
Operating assets are necessary to run a business from day to day. Operating assets generate revenue through a company’s primary business activities.
Examples of Operating Assets:
- Copyrights
- Cash
- Patents
- Inventory
- Machinery
Non-Operating Assets
Non-operating assets generate revenue but are not needed to run the business daily.
Examples of Non-Operating Assets
- Interest Income from a Deposit
- Short-Term Investments
- Securities
- Vacant Land
Being able to classify assets accurately is critical for a business
For example, knowing which assets are current and which ones are fixed helps determine the working capital a company has.
Understanding which assets are operating and non-operating assets let businesses know how much revenue is coming from their core business.
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What Are Liabilities?
The International Financial Reporting Standards (IFRS) define a liability as a
“present obligation of the entity to transfer an economic resource as a result of past events.”
A liability is a financial obligation that a business must repay to another business or company. Liabilities are typically classified as either current or long-term.
Current Liabilities
Current liabilities are due within a year and are a part of normal business operations.
Examples of Current Liabilities:
- Short Term Loans
- Accounts Payable
- Accrued Expenses
- Interest Payable
- Income Taxes Payable
Long-Term Liabilities
Long-term liabilities are due in longer than one year. Therefore, long-term financing, like bonds or mortgages, can be used as a source of financing.
Examples of Long-Term Liabilities:
- Capital Leases
- Mortgage Payable
- Notes Payable
- Bonds Payable
Liabilities are essential in accurately ascertaining a business’s capital structure and liquidity.
What is Equity?
The International Financial Reporting Standards (IFRS) defines equity as the “residual interest in the assets of the entity after deducting all its liabilities.”
Equity is money returned to the owners of a company after its assets have been sold and its debts paid. Equity value is usually measured as either book value or market value.
Book Value of Equity
In accounting, equity is defined by its book value which is determined by examining the balance sheet and financial statements and using the accounting equation.
A company’s assets are the total current and non-current assets on the balance sheet. A company’s liabilities are the total current and non-current liabilities on the balance sheet.
You can adjust the accounting equation to find the book value:
Equity = Assets – Liabilities
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Market Value of Equity
In finance, equity is shown as the market value, which may be substantially lower or higher than the book value. The value differs because financial analysts forecast the financial performance will be where accounting statements are historical.
With publicly traded companies, market value is the latest share price multiplied times the total number of outstanding shares.
Accounting firms, investment bankers, and valuation firms must thoroughly analyze privately-owned companies to be formally valued.
The standard methods to determine equity value are:
- Precedent Transactions
- Discounted Cash Flow
- Comparable Company Analysis
Accurately calculating book value or market value equity can be difficult for businesses as many underlying factors go beyond simply looking at assets and liabilities.
Conclusion
The accounting equation has three components: assets, liabilities, and equity. It is the backbone of dual-entry accounting and ensures that a company’s balance sheet remains balanced.
Multiple properties and classifications of assets impact how and where they show up on a company’s balance sheet.
Current and long-term liabilities each impact a bottom line differently.
Equity Value can be straightforward from an accounting perspective but quite complicated from a financing point of view.
Many business owners work with a trusted accounting firm to assist with their day-to-day accounting needs because of the time and effort it takes to keep a company’s books up to date and accurate.
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