It is important that business owners and accountant do not underestimate the importance of accounting equation analysis. Understanding the function of this equation is necessary to reading a balance sheet, as well is in comprehending a company’s financial statements on the whole.
A company’s quarterly and annual reports are, in essence, derived directly from the accounting equations used in bookkeeping practices. These equations, entered in a business’s general ledger, will provide the material that eventually makes up the foundation of a business’s financial statements. This includes expense reports, cash flow, interest and loan payments, salaries, and company investments.
Double Entry Bookkeeping System
The importance of the accounting equation also lies in its status as the foundation of the double entry bookkeeping system. This accounting system ensures that a company’s accounts are always balanced and that all financial transactions are documented in detail. The primary aim of the double entry system is to keep track of debits and credits, and ensure that the sum of these always matches up to the company assets: a calculation carried out by the accounting equation.
Income and Retained Earnings
Use of the accounting equation is also an essential component in computing, understanding, and analyzing a firm’s income statement. This statement reflects profits and losses that are themselves determined by the calculations that make up the basic accounting equation. In other words, this equation allows businesses to determine revenue and later, to prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly; in other words, the accounting equation is an essential step in determining company profitability.
Because the balance sheet is founded on the principles of the accounting equation (a formula which likewise allows accountants to compile and analyze the details on this sheet), this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets.
Due to its role in determining a firm’s net worth, the accounting equation is also an incredibly important tool for investors. The equation can illuminate a company’s holdings and debts at any particular time, and frequent calculations can indicate how steady or erratic a business’s financial dealings might be. This provides highly valuable information to creditors or banks that might be considering a loan application or investment in the company. If the accounting equation illuminates consistently low assets or frequently high liabilities, they may be less apt to buy into a company.
In short, a business’s entire balance sheet—and thus the record of all financial transactions—relies wholly on accurate use of the accounting equation. The equation not only provides the material for basic calculations and expense reports, but also provides the details and records that ultimately allow businesses to plan out future budgetary strategy.