Steps to calculate the accounting equation

If this is your first time hearing this it might look surprising to you. Accounting equation! But if you're an accounting guru, you already know what it is about and when to use them. For resource purposes, we will explain the steps in the equation and its uses. 

What's the accounting equation

It is the equation that explains the double entry principle and the balancing of the balance sheet. A proper understanding of the accounting equation will guide everything you do in your practice of accounting. Therefore, it is the right foundation in the accounting profession.

Accounting equation formula

The formula of the accounting equation is simple,

1. ASSETS = CAPITAL + LIABILITIES

However, there are variations in the formula. It can also be written as follows:

2. CAPITAL = ASSETS - LIABILITIES

3. LIABILITIES= ASSETS - CAPITAL

The variations in the accounting equation arise due to missing values. If liabilities and capital or equity are known. Then, the first formula is used. However, when capital is unknown the second formula is used and when liabilities are not known the third formula provides the answer.

Expanded accounting equation formula

We can further expand the formula to the accounting equation. That is 

4. ASSETS = LIABILITIES + EQUITY + RETAINED PROFIT B/F + REVENUE - EXPENSES - DIVIDENDS

In the fourth formula, retained profit brought forward, revenue, expenses, and dividends are included. These items affect equity (or capital). Therefore, they can increase or reduce the value of the equity of the firm.

Steps in Calculating Accounting Equations

The following steps can be complied with when computing an equation:

Step 1: 

Calculate the value of the assets of the entity. This includes land and buildings, generators, computers, debtors (account receivables), cash in the business and cash at the bank, furniture, fittings, and so on.

Step 2: 

Find the value of liabilities including the amount owing to banks and trade creditors (account payables), taxes unpaid, rent yet to be paid but already in use by the entity, and so on.

Step 3: 

The capital or equity value is the amount used to start the business. In many small businesses, this is unknown. Therefore, the second formula will be useful in computing the value.

Step 4: 

When all the values are known (that is, you know the value of assets, liabilities, and capital), the first formula is used. Therefore, it is expected that the addition of liabilities and capital should give the value of assets. 

Step 5: 

When the values are not equal, the following should be determined. When the asset values are higher than the liabilities and capital values, assume the value of capital is not known, then use the second formula. However, if you are sure of the value of capital, then use the third formula to find the correct value of liabilities. In the case where the assets value is lower than that of liabilities and capital use equation one to get the correct values for the assets. 

Uses of the accounting equation

The accounting equation is useful in the following instances

1. Commencement of trade: 

Here, the formula can be used to open the books of accounts. Therefore, an opening journal entry showing the assets, liabilities, and capital used to begin the business is stated and their respective ledger accounts are opened at the commencement date of the business.

2. Incomplete business records:

When a business has been in operation for years and does not keep proper accounting records, the accounting equation is a powerful tool to use. It can be used to open the business books. As well as compute previous profits or losses during the periods where there were no proper accounting records.

3. Understand Statement of financial position:

The formula will help professionals track the statement of financial position also referred to as balance sheet. The accounting equation explains how the financial position statement behaves. 

4. Find missing values:

It is also a very powerful tool for finding missing values in the statement of financial position and income statement of a business with incomplete records or single-entry records. Some aspects of fraud may be traced starting with the accounting equation.

5. Used to compute profit or loss:

This is especially true for entities with incomplete records and single entries. Through the accounting equation, their profit or loss can be determined.