Accounting Equation
In case of any business firm, the accounting equation forms the basis of its balance sheet. The equation states that:
Assets = Liabilities + Equity
If we consider a horizontal balance sheet, all assets will be recorded on the right-hand side. All the liabilities along with the equity amount shall be recorded on the left-hand side. Following the accounting as mentioned earlier equation, all the assets (written on the right-hand side) shall be equal to the sum of the liabilities and equity (written on the left-hand side).
Now, we shall first discuss the terms – “assets,” “liabilities,” and “equity.” Assets are resources owned by a business from which benefit is expected to be received over some time, long or short. “Liabilities” are the obligations of a business, and these have to be paid back by the firm over a given period. “Equity” refers to the funds brought in by the owners of a business to finance the same.
The accounting equation is not only valid in case of the balance sheet but is also valid in any business transaction. Say, for example, when a firm raises funds from the markets in the form of debentures, there is an increase in assets in the form of bank/cash. Also, the liabilities of a firm increase to the extent of the number of debentures. It can be shown as follows:
Assets (increase) = Liabilities (increase) + Equity (constant)
This is an example where both assets and liabilities increase by an equal amount while the equity remains constant. There may also be similar cases where change may take place only on one side of the equation.This means specific amounts of liabilities and equity may change such that the amount of the total assets remains constant.
Assets
Assets are one of the three significant elements of a balance sheet, the other two being liabilities and equity. An ‘asset’ is a resource which a business entity owns and controls and out of which financial benefits are expected to be derived in the future. Examples include goodwill, plant and machinery, stock, investments, cash, and bank balance.
Types of assets:
1. Fixed Assets
2. Current Assets
3. Fictitious assets
Fixed Assets are those from which economic benefits shall be derived in the future for more than one year. Once acquired, these assets remain in the business for the long term. Examples include land, building, plant & machinery, furniture, vehicles, etc.
Sub-types of fixed assets:
Tangible Assets – These are assets which are visible to eyes and can be physically handled. Examples include machinery, building, vehicles, furniture, etc.
Intangible Assets – These are assets which are invisible in nature. Examples include patents, copyrights, trademarks, goodwill, etc.
Current Assets are those from which economic benefit shall be derived in the future for less than a year and can also be called short-term assets. Examples include accounts receivable, inventory, short-term investments, cash, and bank balance.
Fictitious Assets are not assets at all. These are accounting entries which have considerable value for the business, hence recorded. Examples include deferred revenue expenditure, discount on issue of shares, etc. These are gradually written off over some time until it remains of some value for the business.
Apart from those above, there are various business assets which are extremely valuable but cannot be accounted for and recorded in books. These include brand value, team spirit of management, loyal customer base, etc.
Liabilities
Liabilities are one of the three significant elements of a balance sheet, the other two being assets and equity. A ‘liability’ is an amount for which a business entity has agreed in its past that it shall payback in future. In other words, the entity has either enjoyed any benefit earlier for which the obligation has arisen to pay (example: car purchased on credit, salary payable) or it has committed to providing benefits or services in the future for which it has already received an amount in advance (advance received from debtors, AMC – annual maintenance charges received in advance for 12 months).
Like equity, liabilities are also a means of providing funds to a company – the difference being that the liability holders are not the owners of the company (as in case of equity). Examples include debentures, long-term debt, overdraft, mortgage loans, etc. Liabilities may be settled either by paying cash or in the form of goods and services.
Types of liabilities:
Long-term Liabilities – These are obligations which shall not become payable within a span of one year. Examples include debt taken from financial institutions, bonds, debentures, mortgages, etc.
Short-term Liabilities – These are obligations of a company which is due to be paid back within a period of one year. These are basically required to paid-back out of the current assets of the company. Examples include trade payables, wages payable, income tax payable, accrued expenses, etc.
Before making any investment in a company, one must have a look at the number of its liabilities in order to know its creditworthiness. Lesser the liabilities, lesser is the risk. A debt-free company is considered to be a risk-free investment in the world of financing.