The Balance Sheet equation also known as Accounting equation is the fundamental principle of accounting. It shows what a company owns, what a company owes, and what stake the owners have in the business. It forms the basis for the Double entry system of accounting. Double entry accounting is a system which ensures that every transaction has two aspects and both aspects of the transaction are recorded in the books of accounts.
This means that for every change in the assets account there must be an equivalent change in the related liability or equity account.
The Balance Sheet Equation looks like this :
Assets = Liabilities + Equity
COMPONENTS OF BALANCE SHEET EQUATION
There are 3 components of a balance sheet equation, namely :-
- ASSETS :- An asset is a resource that is owned or controlled by a company and will provide a benefit in current and future periods for the business. For example, Plant & machinery, goodwill, furniture etc.
- LIABILITIES :- A liability is something a person or company owes, usually a sum of money.In simple words, Liabilities are the present obligations of the company which arises from some past event. For example , accounts payable, wages & salaries due etc.
- EQUITY :- Equity is the amount of capital invested or owned by the owner of a company. It is the net amount of funds invested in a business by its owners, plus any retained earnings.
EXAMPLE OF BALANCE SHEET EQUATION
XYZ Limited has the following items on its balance sheet on a particular date :
Assets = Rs 5,00,000
Liabilities = Rs 1,00,000
Shareholders’ equity = Rs 4,00,000
Now, adding the liabilities & shareholders’ equity , we get :-
Rs 1,00,000 + Rs 4,00,000 = Rs 5,00,000 which is equal to the total assets of the firm.
ADVANTAGES OF BALANCE SHEET EQUATION
- Error can be tracked easily while preparing financial statements with the help of accounting equation.
- It gives a rough idea about the financial position of the firm to the creditors & shareholders.
- It shows the effect of each transaction on owner’s equity, liability and assets.
- It helps to calculate various accounting ratios.
DISADVANTAGES OF BALANCE SHEET EQUATION
- It focuses only on the items of personal and real accounts, not the items of nominal accounts.
- The report of the Balance Sheet does not always give the true and exact status of the company’s finance to the investors & shareholders.
Thus, in simple words the Balance sheet equation is the basic element of balance sheet and ensures that for every debit there is an equal and opposite credit & the company’s assets are always equal to the sum of liabilities & equity .