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What Is The Balance Sheet Equation?

Referencing Styles : MLA | Pages : 1
  • University: Aston University
  • Country: GB

Balance Sheet Equation

In financial accounting, a balance sheet can be defined as a financial statement that measures the values of both the assets and the liabilities of the company. An asset is an item from which the company stands to gain money on its transfer or sale to another party. A liability is the obligation arising from the transactions which a company enters into with the third parties. Like trading account and profit and loss account, this is not an account as it does not measure items of a specific nature and provides an overview of all the items which constitute the assets and liabilities of the company. Apart from the assets and liabilities, it also provides the details about the capital structure of the company. The difference between the assets and liabilities constitutes the capital available with a company. This is also known as the balance sheet equation. This is one of the oldest concepts in the field of accounting and is the basis for the double entry system of book keeping. The double entry system suggests that for every debit in a transaction, there is a corresponding credit which is mandatory. Hence, to measure the financial health of an entity at the end of the year and to ensure that there are no misstatements in the books of accounts, balance sheet equation is extremely important. Although it is very helpful, the equation has its set of limitations. The primary disadvantage is the fact that the balance sheet equation does not provide a detailed effect of a transaction. Hence, a double omission of the credit and debit aspects of a transaction will still ensure that the balance sheet discloses the same amount, but the amount is not reliable in reality. It does not deal with the nominal accounts and personal accounts directly. It only contains a net aspect of their results.

Types of Accounts

On a broader level, there are three types of accounts. These are known as personal, real and nominal accounts. There is a concept called golden rules of accounting which guides a user on the usage and the working mechanism of these accounts. All the assets of a firm, which are either tangible or intangible fall under the real accounts. Tangible assets refer to those accounts which can be touched or seen. Intangible assets are those which cannot be classified as tangible. Examples of items which fall under the category of real accounts include building, machinery, stock, goodwill, patents, trademarks and others. The golden rule of this account is to debit what comes in and credit what goes out. For a transaction like purchasing an asset for cash, the balance of cash account goes down and the balance of the corresponding asset goes up. As suggested by their name, personal accounts are related to accounts that belong to individuals, companies, suppliers, capital, drawings and outstanding/prepaid accounts. These include natural persons, artificial persons and representative personal accounts. Natural personal accounts refer to those of regular people like Adam a/c, Eve a/c and others. Artificial personal accounts refer to the accounts of organisation like a school, LLP and other organisations. Representative personal accounts refer to the accounts which indirectly represent a person. Examples of these include wages payable, accounts receivable and amounts paid in advance. The golden rule of a personal account is to debit the receiver and credit the giver. Nominal account refers to the accounts which exist only in name. That is, the representative of these accounts does not actually exist in the practical world. Examples related to these accounts include purchase account, sales account, and salary and commission a/c.  The golden rule of this account is to debit all expenses and losses and credit all incomes and gains.      

Assets, Liabilities and Equity

Assets are the things whose ownership lies with the company. If the company decides to sell them, then it receives a consideration in cash or in kind for the sale of such an asset. These are always preferable by an entity as they indicate that the company can make more money off its resources. However, there should be a limit to which the company can own the non-cash assets as too much investment in assets makes them unproductive or reduces the readily available cash with the company. Examples of assets include stock, building, machinery, furniture and prepaid expenses. There are various classifications of assets based on their nature, time for which a business holds them and usage in the business. Some of them include current assets, non-current assets, tangible assets and intangible assets. Liabilities are the obligations or mandatory payments of a company. These indicate the items which have to be paid by a company to others who have lent amount or services in the past to it. Some of the examples of liabilities include loans or accounts payable, interest payable, payments received in advance and taxes payable in a given financial year. Equity is generally used to denote the concept of shareholder equity or capital. In a corporate organisation, this is the amount that they would receive from a company if the company were to stop doing its business and paid off all of its debts. In general accounting, this is calculated by deducting the liabilities from the assets. This is also known as the net assets of a company. For example, if a company had assets worth 50 lakhs and liabilities of 40 lakhs and was completely financed by the equity shareholder’s funds, then its equity would be 10 lakhs.

Financial Statements and their types

Financial statements are the documents prepared by a company with the intention provide their stakeholders with knowledge of the financial health and performance of the company for a given year. They contain information about the assets, liabilities, incomes, expenditures and cash flows of the company during a financial year. In general, there are four types of financial statements. They are the income statement, balance sheet, statement of changes in equity and the cash flow statement. There is a fifth statement that is prepared by some of the entities. It is known as the statement of retained earnings. The income statement contains a record of the income earned and expenditure incurred by a company during a financial year. The difference between them is known as the profit or loss of the company for a given financial year. The balance sheet records the assets and liabilities of the company. The difference between both of them is known as the equity or the capital of a company. The purpose of statement of changes in equity is to record the net changes that have taken place in the amount of equity of a company for a given year. This includes noting down changes like the additional capital issued during the year, increase in reserves, profit earned during the year and the reduction of any dividends paid to the shareholders. The objective of preparing a cash flow statement is to record all the cash transactions that the business has conducted during the course of a year. While other financial statements can be manipulated with relative ease, cash flow statement is more difficult to manipulate and is considered to be a more reliable estimate of the financial position of a company.

Statement of Retained Earnings

The final type of financial statement that is prepared by an entity is the statement of retained earnings. This is quite similar to the statement of equity in terms of purpose and usage. There are only a few minor differences between the two. Retained earnings is the amount that is held back by a company from past profits earned by it for future usage. It is also known as accumulated profit, accumulated earnings or accumulated retained earnings. The statement which records the changes in the retained earnings for a specified period is known as the statement of retained earnings. This is usually prepared in accordance with the Generally Accepted Accounting Principles (GAAP). The main information provided by this statement is the net income earned by the business in a year, previous retained earnings of a firm and the amount distributed as dividends to the shareholders. The major advantage that firms obtain by preparing this statement is obtaining the confidence of the investors and the market. It is one of the most highly used statement to understand the financial health of a firm. These earnings are not a part of the surplus funds owned by an organisation. In fact, they are the amount that the company has kept aside for some internal purpose or for the process of reinvestment. The retained earnings are higher for a company which operates in the capital intensive sector than a company which operates in the lesser capital industries. In industries like that of the mobile phone industry and other innovation driven ones, the need to have higher retained earnings is more than that of the apparel industry due to the requirement of capital for constant innovation. They are also helpful in making a company fulfil its obligation towards a shareholder.

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